10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM              TO             .

Commission File Number : 0-22350

MERCURY INTERACTIVE CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	77-0224776
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

1325 Borregas Avenue, Sunnyvale, California 94089

(Address of principal executive offices, including zip code)

Registrant’s telephone number, including area code:

(408) 822-5200

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.002 par value

Preferred Stock Purchase Rights

(Title of class)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such a shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES  x    NO   ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).  YES  x    NO   ¨

The aggregate market value of the voting stock held by non-affiliates of the Registrant was approximately $2,849,707,681 as of June 30, 2003, based upon the closing sale price reported for that date on the NASDAQ National Market. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded because such persons may be deemed to be affiliates. This determination of affiliate status is not necessarily conclusive for other purposes.

The number of shares of Registrant’s Common Stock outstanding as of February 27, 2004 was 91,592,821.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for Registrant’s 2004 Annual Meeting of Stockholders to be held May 19, 2004 are incorporated by reference in Part II and III of this Annual Report on Form 10-K.

TABLE OF CONTENTS

		Page
	PART I
Item 1.	Business	1
	General	1
	Products and Services	2
	Customers	6
	Research and Development	6
	Sales, Marketing, and Alliance Partners	7
	Customer Support	8
	Professional Services	8
	Managed Services	8
	Licensing, Pricing, Deferred Revenue, and Seasonality	8
	Competition	9
	Patents, Trademarks, and Licenses	10
	Personnel	11
	Available Information	11
Item 2.	Properties	12
Item 3.	Legal Proceedings	12
Item 4.	Submission of Matters to a Vote of Security Holders	12
	PART II
Item 5.	Market for the Registrant’s Common Equity and Related Stockholder Matters	13
Item 6.	Selected Consolidated Financial Data	14
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 7a.	Quantitative and Qualitative Disclosures about Market Risk	44
Item 8.	Financial Statements and Supplementary Data	46
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	46
Item 9a.	Controls and Procedures	46
	PART III
Item 10.	Directors and Executive Officers of the Registrant	47
Item 11.	Executive Compensation	48
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	48
Item 13.	Certain Relationships and Related Transactions	48
Item 14.	Principal Accountant Fees and Services	48
	PART IV
Item 15.	Exhibits, Financial Statement Schedules and Reports on Form 8-K	49
Signatures		53

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This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Risk Factors.” Our business may have changed since the date hereof, and we undertake no obligation to update the forward-looking statements in this Annual Report on Form 10-K.

Mercury, Mercury Interactive, the Mercury Interactive logo, ActiveTune, ActiveWatch, LoadRunner, LoadRunner TestCenter, Mercury Business Availability Center, Mercury IT Governance Center, Mercury Performance Center, Mercury Quality Center, ProTune, QuickTest Professional, SiteScope, SiteSeer, TestDirector, Topaz, Topaz Auto RCA, Topaz Business Availability, Topaz Diagnostics, Topaz EMS Adapters, Topaz Open API, Topaz SiteScope, Topaz for SLM, and WinRunner are trademarks and/or registered trademarks of Mercury Interactive Corporation or its subsidiaries in the United States and/or other countries. The absence of a trademark from this list does not constitute a waiver of Mercury Interactive’s intellectual property rights concerning that trademark.

This Annual Report on Form 10-K contains references to other company, brand, and product names. These company, brand, and product names are used herein for identification purposes only and may be the trademarks of their respective owners. Mercury Interactive Corporation disclaims any responsibility for specifying which marks are owned by which companies or which organizations.

PART I

Item 1.    Business

General

Industry Overview

Global enterprises and information technology (IT) professionals are under tremendous pressure today to maximize the business value of IT. It is increasingly difficult for chief information officers (CIOs) to deliver business value from IT while managing costs, risks, and compliance against a changing backdrop of increasing business and technology complexity. To address these challenges, we believe many of the world’s leading companies are turning to business technology optimization (BTO), the industry strategy for maximizing the value of IT. BTO applies business and quality management practices coupled with software to optimize the business results of IT. BTO represents a best-practices approach to IT strategy, application quality, and performance to improve business outcomes. The alignment of business and IT strategy, combined with the optimization of software applications, enables companies to drive more business value from IT while reducing costs and controlling risks.

Company Overview

Mercury is a leading provider of software and services for the BTO marketplace. Mercury was incorporated in 1989, and began shipping software quality testing products in 1991. Since 1991, we have introduced a variety of BTO software and service offerings, including offerings in application delivery (pre-production quality and performance testing), application management (in-production application performance management), and, following the acquisition of Kintana, Inc. in August 2003, IT governance.

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Our BTO offerings for application delivery, application management, and IT governance help customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance. The Mercury BTO offerings focus on five critical IT functions:

• Our application delivery offerings help customers test and tune their custom and packaged business applications to improve the quality and performance of those applications, while reducing the time and costs required to deploy them.

• Our application management offerings help customers optimize the performance and availability of applications in production and resolve problems quickly and proactively.

• Our IT governance offerings help customers govern and manage the people, projects, and processes required to run an IT organization as a business.

• In addition, many of our offerings are available as a managed service over the Internet. With this “software as a service” offering, customers have the flexibility of choosing which Mercury software to run themselves and which software will be outsourced to us.

• We also provide a wide range of customer support and professional service offerings that enable our global partners and customers to implement, customize, manage, and extend Mercury Optimization Center offerings. Our optimization centers are designed to align disparate IT functions by consolidating and centralizing the software, services, and best practices used for application delivery, application management and IT governance.

2003 Business Acquisitions and Technology License Agreement

On May 5, 2003, we acquired all of the outstanding common stock and assumed the unvested stock options of Performant, Inc., a provider of Java 2 Enterprise Edition (J2EE) diagnostics software. Performant’s technology pinpoints performance problems at the application code level. The Performant acquisition allows our customers to diagnose J2EE performance issues across the application delivery and management cycle from pre-production testing to production operations.

On June 30, 2003, we entered into a non-exclusive agreement to license technology from Motive, Inc., a provider of ecosystem blueprinting technology. The relationship with Motive gives us the ability to provide proactive, automated problem resolution in our application management offerings.

On July 11, 2003, we acquired technology assets from Allerez Corporation, a privately held provider of reporting and analytics technology. The acquisition of the Allerez technology will extend the customized reporting capabilities in our application delivery and application management software.

On August 15, 2003, we acquired Kintana, Inc., a leading provider of IT governance software and services. By adding the Kintana product line, we expanded our offerings to help our customers to govern and manage the priorities, processes, and people required to run IT as a business.

Products and Services

In the third quarter of 2003, as part of our continued execution against our BTO technology, we announced our new Mercury Optimization Centers. Mercury Optimization Centers consist of integrated software, services, and best practices that enable IT functional teams to work in a centralized fashion, to save time, cut costs, and increase the effectiveness of critical IT activities.

Application Delivery Offerings

Our application delivery offerings help customers to optimize the quality and performance of both customer-built and pre-packaged software applications before they go into production. We offer two Mercury

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Optimization Centers for application delivery that automate critical delivery functions, including test management, business-process test design, functional testing, load-testing, performance tuning, and diagnostics. This technology is used to optimize the pre-production software development, customization, and integration processes. These Mercury Optimization Centers enable customers to make informed “go live” decisions, decrease software defects, reduce the time and cost of deploying new software or software upgrades, and help ensure that software applications will produce their intended business results. In addition, certain of the capabilities of our two optimization centers are available through a managed service as our application delivery services.

Mercury Quality Center

Mercury Quality Center is used to test the functionality and optimize the quality of business applications before they are deployed. Automated testing ensures that software applications perform the business processes required to ensure user success. Mercury Quality Center provides functional testing and business process testing capabilities, as well as a comprehensive test management solution that allows customers to share information and other testing assets across the enterprise.

Mercury Quality Center core products include:

• TestDirector is a global test management product that helps organizations deploy high-quality applications more quickly and effectively. TestDirector software integrates requirements management with test planning, test scheduling, test execution, and defect tracking in a single application to accelerate the quality testing process.

• QuickTest Professional and WinRunner are automated functional, regression, and user acceptance testing products for Windows-based, Web, enterprise resource planning (ERP) and customer relationship management (CRM), .NET, and Java/J2EE applications. By capturing, verifying and replaying user interactions automatically, QuickTest Professional and WinRunner software identify defects and help ensure that business processes deliver the expected results and remain reliable throughout its lifecycle. QuickTest Professional software is available for browser-based and Java-based applications and ERP/CRM solutions. QuickTest Professional software was initially released in 2001. WinRunner software is available for Windows 98, Windows 2000, Windows Me, Windows XP, and Windows NT platforms.

Mercury Performance Center

Mercury Performance Center is used for optimizing business applications to ensure they scale to support the right number of users, transaction volumes, and performance levels in complex heterogeneous computing environments. Mercury Performance Center includes integrated capabilities for load-testing, performance tuning, and diagnostics.

Mercury Performance Center core products include:

• Mercury LoadRunner TestCenter software is a global load-testing offering that enables organizations to manage multiple, concurrent load-testing projects across geographic locations. Mercury LoadRunner TestCenter is used as the enabling platform for companies developing a center of excellence to support application and infrastructure consolidation projects. It controls all aspects of large-scale performance load-testing projects, including resource allocation and scheduling from a centralized location accessible via the Web.

• Mercury LoadRunner software is the industry-leading load-testing application for predicting system behavior and performance of enterprise applications. It exercises an entire enterprise infrastructure by emulating thousands of users and transactions while employing performance monitors to identify and isolate scalability problems at different levels of the technology stack. By using Mercury LoadRunner, customers can minimize testing cycles, reduce defects, optimize application performance, and accelerate

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application deployment. Mercury LoadRunner is available on a wide range of platforms, including Windows NT, Windows 2000, Windows XP, Sun Solaris, HP-UX, IBM AIX, and Linux.

• Mercury Diagnostic software is comprised of two diagnostics modules acquired in conjunction with the Performant acquisition. Mercury LoadRunner Transaction Breakdown for J2EE helps customers rapidly identify and resolve J2EE applications performance problems. Mercury J2EE Deep Diagnostics is designed to solve code or configuration issues in production, staging, and testing. With these two J2EE diagnostic modules, customers can compress testing and tuning cycles, increase productivity, and accelerate performance problem repairs.

• ProTune software is an automated performance tuning application. It applies a consistent and holistic methodology to automate the process of infrastructure and application optimization. Using ProTune, customers are able to isolate and resolve problems in a logical, systematic way before they impact end users.

Application Delivery Services

• ProTune Delivery Service (formerly ActiveTune) software is a professional service for tuning and optimizing production systems across the entire system — application, database, and infrastructure. It isolates and resolves performance problems in production or pre-production environments.

• ProTune Validation Service (formerly ActiveTest) is a managed service for full-scale capacity validation testing of Web sites and business critical Web-based applications. Using ProTune Validation Service software, our professionals help customers identify performance bottlenecks and capacity constraints.

• Mercury J2EE Deep Diagnostics Service is a packaged service for quickly diagnosing complex J2EE application performance problems across all tiers of the technology stack — down to transaction instance and source code level. This service is designed to identify difficult application performance problems and help customers resolve costly problems, in pre-deployment or in production.

Application Management Offerings

Our application management offerings help customers optimize business availability and problem resolution. We offer one Mercury Optimization Center as well as a managed service for application management that facilitate a strategic, business-centric approach to ensuring that production software performs at the levels required to meet business goals. Additionally, our application management offerings enable customers to proactively manage and automate the repair of production problems, which reduces the business ramifications of downtime.

Mercury Business Availability Center

Mercury Business Availability Center enables IT operations teams to maximize business availability, manage IT operations from a business perspective, minimize downtime, and ensure applications are meeting established service levels with customers. It includes integrated applications and a business dashboard for monitoring and managing availability, service levels, and customer impact—all from an end-user, business point of view. In addition, our customers can choose to have the Mercury Business Availability Center delivered as a managed service.

Mercury Business Availability Center core products include:

• Topaz Diagnostics is used to identify and diagnose the root cause of end-user performance problems. With Topaz Diagnostics, customers can reduce the time spent locating the source of problems and thereby resolve issues faster.

• Topaz for Service Level Management (SLM) enables IT to manage service levels from the business perspective via service level agreement (SLA)-compliant reporting for complex business applications in

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distributed environments. It enables enterprises and service providers to measure application service levels against preset business objectives.

• Topaz Business Availability software is an interactive dashboard that provides real-time visibility into key application-enabled business processes. By monitoring application performance and availability in real-time, Topaz Business Availability helps IT and business executives measure the results delivered by a software application.

• Mercury Application Management Foundation (formerly Topaz Platform) offers an “agentless” monitoring architecture that includes our business process and end user monitoring infrastructure, as well as an infrastructure monitoring solution. Key components include:

• Topaz Business Process Monitor software (formerly ActiveAgent) proactively monitors enterprise applications in real-time and alerts IT Operations groups to performance problems.

• Topaz Client Monitor software (formerly Topaz Observer) gathers performance data directly from devices including desktops, laptops, and PDA’s as they execute transactions on applications.

• Topaz Global Monitor software (formerly Topaz Rent-a-POP) provides a monitoring infrastructure that allows customers to gain insight into the end-user experience both inside and outside the firewall, from a single source.

• Topaz Real User Monitor software (formerly Topaz Prism) is a solution for measuring the online experience of every user, from every location, all the time. With Topaz Real User Monitor, customers can quantify the business impact of performance problems and effectively prioritize resolution efforts.

• Mercury SiteScope software features an “agentless” architecture that is suited to monitoring the availability of distributed systems, network services, servers, and applications. SiteScope was acquired in May 2001 in conjunction with our acquisition of Freshwater.

• Topaz Auto-RCA software speeds problem resolution through automated root cause analysis (RCA).

• Topaz Open API software integrates performance data from other systems management tools across the enterprise.

• Topaz EMS Adapters software integrates enterprise management systems with our application management products.

Application Management Services

• Mercury SiteSeer is our managed service for real-time monitoring and availability that leverages the SiteScope agentless monitoring architecture.

• Topaz Managed Services (formerly ActiveWatch) is our managed service for business availability, performance, and service level management of production applications.

IT Governance Offerings

Our IT Governance offerings are designed to govern and manage the priorities, processes, and people required to run IT as a business. Mercury IT Governance Center helps customers digitize and automate IT business processes from demand through production, enabling them to optimize and align IT strategy and execution.

Mercury IT Governance Center

Mercury IT Governance Center provides integrated capabilities for managing the strategic components of IT. It provides real-time data to consolidate key governance functions such as demand management, portfolio and project management, and resource management, and a comprehensive system to help comply with regulations such as Sarbanes-Oxley Act of 2002. It offers support for quality programs and process control

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frameworks such as Six-Sigma, CMMI, ITIL, ISO-9000, and COBiT. In addition, it integrates workflow, security, execution, and reporting services.

Mercury IT Governance Center core products include:

• IT Governance Dashboard provides real-time visibility into IT priorities, spending, resources, projects, trends, status, and key deliverables.

• Mercury Change Management enables customers to automate software changes across all applications systems and lifecycle phases.

• Mercury Demand Management enables customers to consolidate and manage the business demands and requests being placed on IT.

• Mercury Financial Management enables customers to align IT budgets, activities, and costs.

• Mercury Portfolio Management enables customers to manage IT portfolios in real-time.

• Mercury Program Management enables customers to digitize complex Program Management Office (PMO) processes.

• Mercury Project Management enables customers to enable collaborative project management.

• Mercury Resource Management enables customers to manage resources for strategic projects as well as day-to-day activities.

• Mercury Time Management enables customers to manage time and work, including project tasks and day-to-day activities.

• Mercury IT Governance Foundation provides an integrated transaction processing architecture with shared services across all IT governance applications.

Customers

Our customers represent global leaders and mid-tier companies in a wide range of industries and levels of government. Representative customers from which we generated significant orders in 2003 include companies such as Bank of America, DHL, DaimlerChrysler, Fidelity, Hewlett Packard, IBM, Liberty Mutual, Lockheed Martin, Nationwide, Pfizer, Royal Bank of Scotland, SBC Communications, Siemens, T-Mobile, Toyota Motor, Vodafone, and Volkswagen.

Research and Development

Since our inception in 1989, we have made significant investments in research and product development. We believe that our success will depend in large part on our ability to maintain and enhance our current product line, develop new products and solutions, maintain technological competitiveness, extend our technological leadership, and meet changing customer requirements.

In addition to the teams developing application delivery, application management, and IT governance centers, products and services, we maintain a research organization that is responsible for exploring new strategies and applications of core technologies, migrating new technologies into the existing product lines, acquiring or licensing certain technologies or products from third parties, and maintaining research relationships outside our organization both within industry and academia. Our research and development organization also maintains relationships with third-party software vendors and with many major hardware vendors on whose platforms our products operate.

Our primary research and development facility is located near Tel Aviv, Israel. Performing research and development in Israel offers a lower cost structure than in the U.S. Operating in Israel has also allowed us to receive tax incentives from the government of Israel (see Note 11 to the consolidated financial statements for

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additional information regarding our income tax provision). Our Israeli engineers typically hold advanced degrees in computer-related disciplines from leading academic institutions.

We also have engineering facilities in Boulder, Colorado; Bellevue, Washington; and Sunnyvale, California that were acquired in conjunction with our acquisitions of Freshwater in May 2001, Performant in May 2003, and Kintana in August 2003, respectively.

For the years ended December 31, 2003, 2002, and 2001, we incurred $55.6 million, $42.2 million, and $40.7 million in research and development expenses, excluding stock-based compensation of $0.3 million, $0.5 million, and $0.6 million, respectively. As of December 31, 2003, our research and development organization consisted of 539 employees.

Sales, Marketing, and Alliance Partners

Sales

We employ highly skilled enterprise sales professionals and systems engineers to understand our customers’ needs and to explain and demonstrate the value of our products and services. We sell our products primarily through our direct sales organization, which is supported by our pre-sales systems engineers. Our sales organization also includes our inside corporate sales professionals, who are primarily responsible for smaller transactions with existing customers. As of December 31, 2003, our sales organization consisted of 820 employees.

Our subsidiaries and branches operate sales and support offices in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. As of December 31, 2003, we had a total of 68 sales and support offices throughout the world, of which 38 were in the Americas, 20 were in EMEA, 8 were in APAC, and 2 were in Japan.

Marketing

Our marketing organization is primarily responsible for promoting our BTO strategy through a number of marketing campaigns, including our BTO executive summit, business and trade press tours, industry analyst briefings, global advertising and lead generation campaigns targeted at senior IT executives. In fiscal 2003, marketing activities included direct mailings to customers and prospects, as well as attendance and sponsorship at strategic industry events and tradeshows. We also hosted a series of seminars to specific resellers, end-users, and prospects designed to familiarize attendees with the capabilities of our BTO vision and Mercury Optimization Center offerings. As of December 31, 2003, our marketing organization consisted of 135 employees.

Alliance Partners

We work with a wide range of partners around the globe. Our strategy is to partner with global software vendors, global systems integrators, value-added resellers, and database infrastructure vendors to provide our customers with a wide breadth and depth of leading software and services to get the most value out of their BTO implementations and strategies. These companies include:

• global software vendors that provide enterprise applications, such as Oracle, PeopleSoft, SAP AG, and Siebel Systems;

• major systems integrators, including Accenture, BearingPoint, Cap Gemini Ernst & Young, and IBM Global Services; and

• IT application infrastructure vendors such as BEA Systems, Citrix Systems, Hewlett-Packard, IBM, Oracle, and Sun Microsystems.

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We derive a portion of our business from sales of our products through our alliance partners, which include value-added resellers and major systems integration firms including Accenture, BearingPoint, Cap Gemini Ernst & Young, IBM Global Services, and others on a worldwide basis. We normally pay our alliance partners through our channel business in the form of a discount or a fee for the referral of business, which is netted against revenue recognized.

Customer Support

Our customer support organization provides post-sales support through renewable maintenance contracts. These contracts provide for technical support as well as software upgrades on an “if and when available” basis. Our customer support organization offers different customer support programs to suit varying needs of our global customers. Our development teams in Israel serve as an extension of our customer support organization to assist when local support centers are unable to solve a problem. We believe that a strong customer support organization is integral to both the initial marketing of our products and maintenance of customer satisfaction, which in turn enhances our brand and improves opportunity for repeat orders. In addition, the customer feedback received through our ongoing support function provides us with information on market trends and customer requirements that are strategic to ongoing product development efforts. As of December 31, 2003, our customer support organization consisted of 206 employees.

Professional Services

Our professional services organization offers the expertise, knowledge, and practices to help the customer implement an enterprise-wide BTO strategy. We help the customer measure the quality of their applications and automated business processes from a business perspective, maximize technology and business performance at each stage of the application lifecycle, and manage IT operations for continuous improvement. We offer courses in a variety of topics, methods of delivery, and locations. Post-sales support is provided by our professional services organizations through training and consulting engagements. As of December 31, 2003, our professional services organization consisted of 192 employees. In addition, our certified partners are able to assist our customers with the implementation of our entire portfolio of Mercury Optimization Center offerings.

Managed Services

Our managed services offerings are a strategic part of our overall support strategy to help ensure that our customers are successful with our application delivery, application management, and IT governance Mercury Optimization Centers. These services offer customers the choice to run Mercury software in-house or have us provide them with an outsourced offering. By deploying our software as a service over the Internet, our managed services help our customers rapidly derive more value from their IT investments while minimizing costs and risks. Our managed services provide an infrastructure that consists of server farms, a robust infrastructure for managing data, and more than 400 agent machines located in more than 80 cities around the world. In addition, to help customers be successful in implementing our BTO products, our managed services can be augmented with on-going knowledge transfer from our professional services. We believe that offering our customers the choice of whether to run Mercury software internally or have us provide it as a managed service is a significant competitive advantage over vendors who only offer one or the other option. As of December 31, 2003, our managed services organization consisted of 85 employees.

Licensing, Pricing, Deferred Revenue, and Seasonality

We license our software to customers under non-exclusive license agreements on either subscription, perpetual, or multiple year term bases that generally restrict use of the products to internal purposes at a specified site. We typically license software products to either allow up to a set number of users to access the software on a network at any one time, using any workstation attached to that network, or to allow use of the software on designated computers or workstations. In addition, our managed services, our application management products,

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and some of our application delivery and IT governance products are licensed and priced based on usage, such as the number of transactions monitored, number of virtual users emulated per day, or period of usage.

We believe that offering customers term and subscription license contracts provides us with an unique differentiator. Term and subscription licensing enable Mercury customers to license the software they need for the time period they use it, while providing Mercury with the opportunity to earn renewals and contract expansion over time.

Our products are priced to encourage customers to purchase multiple products and licenses and expand the usage of our technology. License fees depend on the product licensed, the term of the license, the number of users for the product licensed, and the locations in which such licenses are sold, as international prices tend to be higher than U.S. prices. Sales to our indirect sales channels, which are intended for resale to end users, are made at discounts from our list prices based on the sales volume of the indirect sales channels. Original purchases of maintenance and renewal maintenance sales are priced at specified percentages of the related license fees. Training and consulting revenues are generally generated on a time and expense basis.

We recognize revenue ratably from subscription contracts whose terms generally range over a period of one to three years. Recognized revenue from these contracts was $98.9 million, $53.0 million, and $32.8 million for the years ended 2003, 2002, and 2001, respectively. As of December 31, 2003, based on subscription contracts sold as of such date, we expected to recognize $94.7 million of subscription revenue in fiscal 2004, and $55.2 million in periods after fiscal 2004. In addition, we enter into a small number of maintenance contracts that have terms greater than one year. Recognized revenue from these contracts was $15.3 million, $11.2 million, and $8.2 million for the years ended 2003, 2002, and 2001, respectively. As of December 31, 2003, based on maintenance contracts sold as of such date, we expected to recognize $101.3 million of maintenance revenue in fiscal 2004, and $8.4 million in periods after fiscal 2004.

We do not have any sales contracts that obligate our customers to buy any material products or services over future periods other than those sales recorded as either revenues or deferred revenues.

We have experienced seasonality in our orders and revenues which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth fiscal quarters, from our application management business being typically strongest in the fourth fiscal quarter and weakest in the first fiscal quarter, and to a lesser extent, from the structure of our sales commission program. We expect this seasonality to continue in the future.

Competition

The market for our business technology optimization products and services is extremely competitive, dynamic, and subject to frequent technological change. Currently we have no direct competitor offering BTO software across IT governance, application delivery, and application management. Over time, we do expect software vendors to attempt to build comprehensive BTO offerings to compete directly with us. We do experience competition in the various market areas of BTO. There are few substantial barriers of entry into our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in our markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

In the BTO market for application delivery, some competitors include Compuware, Empirix, IBM Software Group, Segue Software, and others. In the new and rapidly changing markets for application management, some

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principal competitors include vendors of systems and network management software such as BMC Software, Computer Associates, HP OpenView (a division of Hewlett-Packard), and Tivoli (a division of IBM), and providers of hosted services such as Keynote Systems. Additionally, we face potential competition in this market from existing providers of application delivery solutions such as Segue Software and Compuware. In the market for IT governance solutions, our principal competitors include application vendors such as SAP, PeopleSoft, Oracle, and Lawson, as well as point tool vendors such as Primavera and Niku.

We believe that the principal competitive factors affecting our market are:

• price and cost effectiveness;

• product functionality;

• product performance, including scalability and reliability;

• quality of support and service;

• company reputation;

• depth and breadth of BTO offerings;

• R&D leadership;

• financial stability;

• flexibility of our licensing model;

• global capabilities; and

• alliance partnerships.

Although we believe that our products and services currently compete favorably with respect to these factors, the market for application management is growing, the market for application delivery is evolving, and the market for IT governance is emerging. We may not be able to maintain our competitive position, which could lead to a decrease in our revenues. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. For example, our former application delivery competitor, Rational Software, was acquired by IBM Software Group. Our competitors and potential competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies, or make more attractive offers to distribution partners and employees. Additionally we anticipate the possibility of application delivery and application management vendors expanding their offerings by acquiring or developing IT governance and managed service offerings.

Patents, Trademarks, and Licenses

We rely on a combination of patents, copyrights, trademarks, service marks, trade secret laws, and contractual restrictions to establish and protect proprietary rights in our products and services. The source code for our products is protected both as a trade secret and as an unpublished copyrighted work. Despite our precautions, it may be possible for a third party to copy or otherwise obtain and use our products or technology without authorization. In addition, the laws of various countries in which our products may be sold may not protect our products and intellectual property rights to the same extent as the laws of the U.S. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology.

We rely on software that we license from third parties for certain components of our products and services including the ecosystem blueprinting technology we licensed from Motive. In the future, we may license other third party technologies to enhance our products and services and meet evolving customer needs. The failure to license any necessary technology, or to maintain our existing licenses, could result in reduced demand for our products.

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Because the software industry is characterized by rapid technological change, we believe that factors such as the technological and creative skills of our personnel, new product developments, frequent product enhancements, name recognition, and reliable product maintenance are more important to establishing and maintaining a technology leadership position than the various legal protections of our technology.

As of March 1, 2004, we have been granted or own by assignment 23 patents issued in the U.S. and have over 20 patent applications on file with the United States Patent and Trademark Office (including continuation and divisional applications) for elements contained in our products and services. Once granted, we expect the duration of each patent will be up to 20 years from the effective date of filing of the applications. Our earliest two issued patents can remain effective until April 11, 2017. In addition, we have three patents issued in Australia, and over 10 patent applications pending in various countries, including, but not limited to, Canada, Mexico, Japan, Australia, Israel, and the European Union. We intend to continue to file patent applications and maintain our existing patents as appropriate in the future. We cannot be sure, however, that any of our pending patent applications will be allowed, that any issued patents will protect our intellectual property or will not be challenged by third parties, or that the patents of others will not seriously harm our ability to do business. In addition, others may independently develop similar or competing technologies or design around any of our patents. We do not believe we are significantly dependent on any of our patents.

Although we believe that our products and services and other proprietary rights do not infringe upon the proprietary rights of third parties, third parties may assert intellectual property infringement claims against us in the future. Any such claims may result in costly, time-consuming litigation and may require us to enter into royalty or cross-license arrangements.

Personnel

As of December 31, 2003, we had a total of 2,322 employees, of which 1,169 were based in the Americas and 1,153 were based outside the Americas. Of the total, 955 were engaged in marketing and selling, 483 were in services and support, 539 were in research and development, and 345 were in general and administrative functions. Our success depends in significant part upon the performance of our senior management and certain key employees. Competition for highly skilled employees, including sales, technical, and management personnel, is strong in the software and technology industry. We may not be able to recruit and retain key sales, technical, and managerial employees. Our failures to attract, assimilate, or retain highly qualified sales, technical, and managerial personnel could seriously harm our business. Additionally we had changes in the roles, responsibilities, and personnel in our executive management. Any failures of our executive team to adopt and change to these new roles and responsibilities could have an adverse affect on our business. None of our employees are represented by a labor union, we have never experienced any work stoppages, and we believe that our employee relations are in good standing.

Available Information

We are subject to the informational requirements of the Securities Exchange Act of 1934 (the Exchange Act). Therefore, we file periodic reports, proxy statements, and other information with the Securities and Exchange Commission (the SEC). Such reports, proxy statements and other information may be obtained by visiting the Public Reference Room of the SEC at 450 Fifth Street, NW, Washington, DC 20549 or by calling the SEC at 1-800-SEC-0330. In addition, the SEC maintains an Internet website at http://www.sec.gov that contains reports, proxy, and information statements and other information regarding issuers that file electronically.

You can access financial and other information on our website at www.mercuryinteractive.com/company/ir/docs. We have made all reports and amendments to reports from November 15, 2002 to December 31, 2003 available on our website. We also make available, free of charge, copies of our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after filing such material electronically or otherwise furnishing it to the SEC.

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Item 2.    Properties

In October 2003, we leased four buildings with a total square footage of 253,000 in Mountain View, California for our new headquarters. We plan to move into these buildings starting in the second quarter of fiscal 2004. Until that move is completed, we are headquartered in Sunnyvale, California in two buildings that we own with a total square footage of 105,500. In January 2004, we sold two vacant buildings in Sunnyvale, California with a total square footage of 50,000. In addition, we leased office buildings in other locations within the Americas. As of December 31, 2003, we leased approximately 190,000 square feet of office buildings in other locations within the Americas.

Our primary research and development activities are conducted by our subsidiary in Israel in two buildings that we own with a total square footage of 255,000. We also lease two buildings, one of which is used for research and development activities and the other of which is used for manufacturing activities. In February 2004, we purchased approximately 30,000 square feet of land near our existing offices in Israel to accommodate future expansion in research and development activities.

As of December 31, 2003, we had a total of 68 sales and support offices throughout the world, of which 38 were in the Americas, 20 were in EMEA, 8 were in APAC, and 2 were in Japan.

As of December 31, 2003, we leased office buildings in EMEA, APAC, and Japan with a total square footage of 151,000, 31,000, and 7,000, respectively.

We believe that our existing facilities are adequate for our current needs.

Item 3.    Legal Proceedings

There are presently no material legal proceedings pending, other than routine litigation incidental to our business, to which we are a party or to which any of our properties is subject. It is common in our industry to experience legal disputes with customers, shareholders, partners, and/or employees. This type of legal action could significantly harm our business.

Item 4.    Submission of Matters to a Vote of Security Holders

(a) A Special Meeting of Stockholders (Meeting) of Mercury Interactive Corporation was held at our offices at 1325 Borregas Avenue, Sunnyvale, California 94089 at 10:00 a.m. Pacific Standard Time on Wednesday, December 10, 2003.

(b) The following proposals were considered at the Meeting with their results according to the respective vote of the stockholders:

PROPOSAL 1—Ratify and approve the amendment to the Amended and Restated 1999 Stock Option Plan to increase the number of shares reserved for issuance by an additional 3,000,000 shares.

For	Against	Abstentions	Broker Non-Votes
37,123,304	33,217,004	465,868	0

PROPOSAL 2—Ratify and approve the amendment to the Amended and Restated 1998 Employee Stock Purchase Plan to increase the number of shares reserved for issuance by an additional 5,000,000 shares.

For	Against	Abstentions	Broker Non-Votes
58,944,080	11,397,655	464,441	0

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PART II

Item 5.    Market for the Registrant’s Common Equity and Related Stockholder Matters

Market for Common Stock

Our common stock is traded publicly on the NASDAQ National Market under the trading symbol “MERQ.” The following table presents, for the periods indicated, the high and low intra-day sale price per share of our common stock as reported on the NASDAQ National Market.

	High		Low
Year Ended December 31, 2002:
First Quarter	$	42.48	$	28.40
Second Quarter	$	39.98	$	22.00
Third Quarter	$	28.90	$	16.93
Fourth Quarter	$	35.68	$	15.15
Year Ended December 31, 2003:
First Quarter	$	38.63	$	29.28
Second Quarter	$	44.20	$	29.24
Third Quarter	$	52.16	$	37.25
Fourth Quarter	$	52.43	$	42.01

Holders of Record

As of February 27, 2004, there were approximately 354 holders of record of our common stock.

Dividends

We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings for use in our business and do not anticipate paying any cash dividends in the foreseeable future.

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Item 6.    Selected Consolidated Financial Data

	Year ended December 31,
	2003			2002			2001			2000			1999
	(in thousands, except per share amounts)
Consolidated Statements of Operations Data:
Revenues:
License fees	$	201,047		$	192,212		$	203,817		$	206,835		$	130,890
Subscription fees		98,858			53,024			32,783			9,265			—
Total product revenues		299,905			245,236			236,600			216,100			130,890
Maintenance fees		159,030			122,343			98,536			64,250			38,064
Professional service fees		47,538			32,543			25,864			26,650			18,746
Total revenues		506,473			400,122			361,000			307,000			187,700
Costs and expenses:
Cost of license and subscription		29,056			24,804			23,915			15,626			6,327
Cost of maintenance		11,880			11,662			10,712			4,969			2,094
Cost of professional services (excluding stock-based compensation)		36,889			24,334			20,396			21,359			16,173
Marketing and selling (excluding stock-based compensation)		238,765			193,775			182,682			147,077			87,060
Research and development (excluding stock-based compensation)		55,608			42,246			40,726			35,282			25,438
General and administrative (excluding stock-based compensation)		40,000			32,407			24,806			19,274			12,621
Stock-based compensation		5,992			1,163			1,999			—			—
Acquisition related charges		11,968			—			—			—			—
Restructuring, integration and other related charges		3,389			(537	)		5,361			—			2,000
Amortization of goodwill and other intangible assets		7,470			2,375			30,125			—			—
Facilities impairment		16,882			—			—			—			—
Total cost and expenses		457,899			332,229			340,722			243,587			151,713
Income from operations		48,574			67,893			20,278			63,413			35,987
Interest income		34,720			35,119			36,981			30,526			6,847
Interest expense		(19,551	)		(23,370	)		(23,636	)		(11,775	)		—
Net loss on investments in non-consolidated companies		(3,524	)		(5,296	)		—			—			—
Other income (expense), net		(2,524	)		8,043			17,113			(1,289	)		(821	)
Income before provision for income taxes		57,695			82,389			50,736			80,875			42,013
Provision for income taxes		16,182			17,185			16,582			16,175			8,869
Net income	$	41,513		$	65,204		$	34,154		$	64,700		$	33,144
Net income per share (basic)	$	0.48		$	0.78		$	0.41		$	0.81		$	0.44
Net income per share (diluted)	$	0.45		$	0.74		$	0.39		$	0.73		$	0.39
Weighted average common shares (basic)		87,124			83,938			82,559			79,927			76,112
Weighted average common shares and equivalents (diluted)		92,728			87,640			88,567			88,745			85,208
	December 31,
	2003			2002			2001			2000			1999
	(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents and short-term investments	$	706,360		$	527,246		$	427,781		$	628,743		$	171,327
Working capital		523,045			377,343			342,724			556,821			138,711
Total assets		1,970,510			1,075,283			927,625			976,375			297,218
Convertible notes		811,159			316,972			377,480			500,000			—
Stockholders’ equity		700,369			445,168			354,345			303,032			199,531

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Item 7.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933. In some cases, forward-looking statements are identified by words such as “believes,” “anticipates,” “expects,” “intends,” “plans,” “will,” “may,” and similar expressions. In addition, any statements that refer to our plans, expectations, strategies or other characterizations of future events or circumstances are forward-looking statements. Our actual results could differ materially from those discussed in, or implied by, these forward-looking statements. Factors that could cause actual results or conditions to differ from those anticipated by these and other forward-looking statements include those more fully described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors.” Our business may have changed since the date hereof, and we undertake no obligation to update these forward-looking statements.

Overview

Mercury is the leading provider of software and services for the Business Technology Optimization (BTO) marketplace. BTO is a business strategy for aligning IT and business goals while optimizing the quality, performance, and business availability of strategic software applications and systems. Our application delivery, application management and IT governance products and services, and the Mercury Optimization Centers are designed to help our customers increase the business value of IT with BTO.

We have aligned our enterprise software business model with the way we believe customers want to license and deploy enterprise software today. Customers are moving away from the rigidity of perpetual software licenses to flexible term or subscription based contracts. Customers have the choice between running software in-house or having software delivered as a hosted or managed service. Mercury’s enterprise software business model enables our customers to license the right software, for the right period of time, and have it deployed the right way—while giving Mercury the right financial incentives to renew and expand our relationships with customers.

We believe that the success of our model can be seen in our financial results which include significant growth in revenue and deferred revenue. In order to understand our financial results, it is important to understand our changing business model and its impact on the consolidated statement of operations and the consolidated balance sheet. We continue to experience a dramatic increase in the amount of software licenses structured as term or subscription based contracts. The majority of these types of contracts are required to be recorded initially as deferred revenue on the consolidated balance sheet and then recognized in subsequent periods over the term of the contract as subscription revenue in our consolidated income statement (see below under Business Model). Therefore, to understand the full growth of our business, one must look at both revenue and the change in deferred revenue.

Business Model

Revenue consists of fees for the license and subscription of our software products, maintenance fees, and professional service fees. License revenue is comprised of license fees charged for the use of our products under perpetual or multiple year arrangements in which the fair value of the license fee is separately determinable from maintenance and/or professional services. Subscription revenue, including managed service revenue, represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and updates) for a limited period of time. Since subscription licenses include bundled products and services, for which the fair value of the license fee is not separately determinable from maintenance, both product and service revenue is generally recognized ratably over the term. Maintenance revenue is comprised of fees charged for post-contract customer support, which are determinable based upon renewal rates quoted in the contracts, and in the absence of stated renewal rates upon separate sales of renewals to other customers. Professional service revenue is comprised of fees charged for product training and consulting services, which are determinable based upon separate sales of these services to other customers by us.

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Due to the different treatment of subscription and perpetual licenses under applicable accounting rules, each type of license has a different impact on our consolidated financial statements. When a customer buys a subscription license, the majority of the revenue will be recorded as deferred revenue on our consolidated balance sheet. The amount recorded as deferred revenue is equal to the portion of the license fee that has been invoiced or paid but not recognized as revenue. Deferred revenue is reduced as revenue is recognized. Under perpetual licenses (and some multi-year arrangements for which separate vendor specific objective evidence exists for undelivered elements), a higher proportion of all license revenue is recognized in the quarter that the product is delivered, with a lesser proportion recorded as deferred revenue. Therefore, an order for a subscription license will result in significantly lower current-period revenue than an equal-sized order under a perpetual license. Conversely, an order for a subscription license will result in higher revenues recognized in future periods than an equal-sized order for a perpetual license.

Our license revenue in any given quarter is dependent upon the volume of perpetual license orders delivered during the quarter and the amount of subscription revenue amortized from deferred revenue and, to a small degree, revenue recognized on subscription orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). Our ability to achieve our revenue targets is also impacted by the mix of domestic and international sales, together with fluctuations in foreign exchange rates. For the year ended December 31, 2003, our revenues were affected favorably by a weakening of the U.S. dollars relative to other currencies, primarily the Euro and British Pound. Total revenues from international sales for fiscal 2003 was $184.5 million, an increase of $46.9 million, compared to fiscal 2002. $21.7 million of this increase was due to fluctuations in foreign exchange rates. If there is a decrease in value of foreign currencies, our revenues from international sales would be negatively impacted. If we achieve the target license mix but the overall level of orders is below the target level, then we may not meet our revenue targets. In 2002, we changed the mix of software license types to a higher percentage of subscription licenses. We believe that this shift will continue in the future as we offer more products on a subscription basis and more customers license our products on a subscription basis. This shift may cause us to experience a decrease in recognized revenue, as well as continued growth of deferred revenue.

Cost of license and subscription includes direct costs to produce and distribute our products, such as costs of materials, product packaging and shipping, equipment depreciation, and production personnel; and costs associated with our managed services business, including personnel-related costs, fees to providers of Internet bandwidth and related infrastructure, and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel costs and related expenses; and the cost of providing upgrades to our subscription customers. We have not broken out the costs associated with subscriptions because these costs cannot be separated between license and subscription cost of revenue. Cost of professional services includes direct costs of providing product training and consulting, largely consisting of personnel costs and related expenses. License and subscription, maintenance, and professional services costs also include allocated facility and information technology infrastructure expenses.

The costs associated with subscription licenses, which include the cost of products and services, are expensed as incurred over the subscription term. In addition, we defer the portion of our commission expense related to subscription licenses and amortize the expense over the subscription term. See “Critical Accounting Policies” for a full description of our estimation process for accrued liabilities.

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Results of Operations

The following table sets forth, as a percentage of total revenues, certain consolidated statements of operations data for the periods indicated. These operating results are not necessarily indicative of the results for any future period.

	Year ended December 31,
	2003		2002		2001
Revenues:
License fees	40	%	48	%	57	%
Subscription fees	20		13		9
Total product revenues	60		61		66
Maintenance fees	31		31		27
Professional service fees	9		8		7
Total revenues	100		100		100
Costs and expenses:
Cost of license and subscription	6		6		6
Cost of maintenance	3		3		3
Cost of professional services (excluding stock-based compensation)	7		6		5
Marketing and selling (excluding stock-based compensation)	47		48		51
Research and development (excluding stock-based compensation)	11		11		11
General and administrative (excluding stock-based compensation)	8		8		7
Stock-based compensation	1		—		1
Acquisition related charges	2		—		—
Restructuring, integration and other related charges	1		—		1
Amortization of goodwill and other intangible assets	1		1		8
Facilities impairment	3		—		—
Total costs and expenses	90		83		93
Income from operations	10		17		7
Interest income	6		9		10
Interest expense	(4	)	(6	)	(7	)
Net loss on investments in non-consolidated companies	(1	)	(1	)	—
Other income (expense), net	—		1		5
Income before provision for income taxes	11		20		15
Provision for income taxes	3		4		5
Net income	8	%	16	%	10	%

Certain reclassifications have been made to the consolidated statements of operations for the years ended December 31, 2002 and 2001 in order to conform to the current year presentation, specifically the allocation of information technology infrastructure and facility expenses.

Revenues

License fees

License fee revenue was $201.0 million for the year ended December 31, 2003, compared to $192.2 million for the year ended December 31, 2002, an increase of 5%. This increase of $8.8 million in license fee revenues was primarily attributable to the sale of IT governance products acquired through the acquisition of Kintana in August 2003 and an increase of $2.7 million in application management license fees, mainly due to an increase in

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sales of our application management licenses including products acquired through the acquisition of Freshwater. IT governance license fee revenue was $7.6 million in 2003. The increase of license fee revenue was partially offset by a decrease of $1.5 million in application delivery license fee revenue due to more customers licensing our products on a subscription basis. We expect our license fee revenues to increase in absolute dollars in fiscal 2004.

License fee revenue was $192.2 million for the year ended December 31, 2002, compared to $203.8 million for the year ended December 31, 2001, a decrease of 6%. This decrease of $11.6 million in license fee revenue was primarily attributable to a decrease of $14.1 million in application delivery license fees due to a continuous effort to shift to a subscription pricing model and reduced IT spending environment, partially offset by an increase of $2.5 million in application management license fees due to the increase in sales of licenses of our products acquired through the acquisition of Freshwater.

Subscription fees

Subscription fee revenue was $98.9 million for the year ended December 31, 2003, compared to $53.0 million for the year ended December 31, 2002, an increase of 87%. This increase of $45.9 million in subscription fee revenue was primarily attributable to an increase in license sales of $22.9 million in both application management subscription products and services and application delivery subscription due to more products being offered and more customers licensing our products on a subscription basis. We expect sales of our subscription licenses and services to continue to increase in absolute dollars in fiscal 2004.

Subscription fee revenue was $53.0 million for the year ended December 31, 2002, compared to $32.8 million for the year ended December 31, 2001, an increase of 62%. This increase of $20.2 million in subscription fee revenue was primarily attributable to an increase of $11.8 million in application management subscription products and services revenue and an increase of $8.4 million in our application delivery subscription revenue due to an increase in licenses on a subscription basis.

Maintenance fees

Maintenance fee revenue was $159.0 million for the year ended December 31, 2003, compared to $122.3 million for the year ended December 31, 2002, an increase of 30%. This increase of $36.7 million in maintenance fee revenue was primarily attributable to an increase of $32.8 million in application delivery maintenance fee revenue due to renewals of existing maintenance contracts, an increase of $2.2 million in application management maintenance fee revenue due to renewals of maintenance contracts for products including those acquired through the acquisition of Freshwater, and $1.7 million in maintenance fee revenue from the sale of IT governance products acquired through the acquisition of Kintana. We expect that maintenance fee revenue will continue to increase in absolute dollars in 2004.

Maintenance fee revenue was $122.3 million for the year ended December 31, 2002, compared to $98.5 million for the year ended December 31, 2001, an increase of 24%. This increase of $23.8 million in maintenance fee revenue was primarily attributable to an increase of $20.1 million in application delivery maintenance fee revenue due to renewals of existing maintenance contracts and an increase of $3.7 million in application management maintenance fee revenue due to products acquired through the acquisition of Freshwater.

Professional service fees

Professional service fee revenue was $47.5 million for the year ended December 31, 2003, compared to $32.5 million for the year ended December 31, 2002, an increase of 46%. This increase of $15.0 million in professional service fee revenue was attributable to $6.6 million consulting fees for service engagements related to the sale of IT governance products acquired through the acquisition of Kintana. The increase was also

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attributable to an increase of $5.5 million in professional service fees associated with application delivery products and an increase of $2.9 million in professional service fees associated with application management products due to a continuous growth in both of our application delivery and application management product offerings and an effort to increase our professional service offerings to our customers. We expect our professional service fee revenue to continue to increase in absolute dollars in fiscal 2004.

Professional service fee revenue was $32.5 million for the year ended December 31, 2002, compared to $25.9 million for the year ended December 31, 2001, an increase of 26%. This increase of $6.7 million in professional service fee revenue was primarily attributable to an increase of $5.5 million in professional service fees associated with application delivery products and an increase of $1.2 million in professional service fees associated with application management products due to the continuous growth of our application management product offerings.

International sales revenue

International sales represented 36%, 34%, and 35% of our total revenues in 2003, 2002, and 2001, respectively. Our international revenue increased 34% in absolute dollars in 2003, compared to 2002, primarily due to a weakening of the U.S. dollar and improved sales performance in Europe, the Middle East and Africa (EMEA) of $37.2 million, Asia Pacific (APAC) of $9.1 million, and Japan of $0.7 million. Our international revenue increased 8% in absolute dollars in 2002, compared to 2001, primarily due to improved sales performance in EMEA and Japan and foreign currency fluctuations.

Costs and expenses

Cost of license and subscription

Cost of license and subscription was $29.1 million for the year ended December 31, 2003, or 6% of total revenues, compared to $24.8 million for the year ended December 31, 2002, or 6% of total revenues. The increase of $4.3 million was primarily attributable to an increase of $5.2 million in personnel-related costs due to an increased number of employees and an increase in professional service costs of $0.7 million related to subcontractor services provided to certain ProTune customers. The increase was partially offset by a decrease of $0.9 million in allocated facility expenses. Based upon our revenue growth as described in “Revenues,” we expect cost of license and subscription to continue to increase in absolute dollars in fiscal 2004.

Cost of license and subscription was $24.8 million for the year ended December 31, 2002, or 6% of total revenues, compared to $23.9 million for the year ended December 31, 2001, or 6% of total revenues. The increase of $0.9 million was primarily due to an increase of $0.6 million in royalty costs due to an increase in sales of products covered under OEM agreements with third parties and an increase of $0.6 million in allocated facility expenses. The increase was partially offset by a decrease in other expenses such as shipping charges.

Cost of maintenance

Cost of maintenance was $11.9 million for the year ended December 31, 2003, or 3% of total revenues, compared to $11.7 million for the year ended December 31, 2002, or 3% of total revenues. Based upon our revenue growth as described in “Revenues,” we expect cost of maintenance to increase in absolute dollars in fiscal 2004.

Cost of maintenance was $11.7 million for the year ended December 31, 2002, or 3% of total revenues, compared to $10.7 million for the year ended December 31, 2001, or 3% of total revenues.

Cost of professional services

Cost of professional services was $36.9 million for the year ended December 31, 2003, or 7% of total revenues, compared to $24.3 million for the year ended December 31, 2002, or 6% of total revenues. The

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increase of $12.6 million was primarily due to an increase of $11.0 million in personnel-related costs due to an increased number of employees, of which $3.5 million was related to Kintana employees who joined us as part of the acquisition, an increase of $0.9 million in allocated facility expenses, and an increase of $0.9 million in allocated IT infrastructure expenses. These increases were partially offset by a decrease of $0.6 million in outsourcing expense due to a higher utilization of our internal professional services group, resulting in less outsourcing activities. Based upon our revenue growth as described in “Revenues,” we expect cost of professional services to continue to increase in absolute dollars in fiscal 2004.

Cost of professional services was $24.3 million for the year ended December 31, 2002, or 6% of total revenues, compared to $20.4 million for the year ended December 31, 2001, or 5% of total revenues. The increase of $3.9 million was primarily due to an increase of $2.5 million in personnel-related costs due to an increased number of employees and an increase of $1.2 million due to product training payments, which were previously recognized as a contra-expense, reclassified to revenue.

Marketing and selling

Marketing and selling expense consists of employee salaries and related costs, sales commissions, marketing programs and campaigns, and allocated facility and information technology infrastructure expenses. Marketing and selling expense was $238.8 million for the year ended December 31, 2003, or 47% of total revenues, compared to $193.8 million for the year ended December 31, 2002, or 48% of total revenues. The increase of $45.0 million was primarily attributable to an increase of $30.5 million in personnel-related costs due to an increased number of employees and an increase of $3.7 million in commission expense due to an increase in sales revenue and the number of sales employees. This increase included personnel-related costs of $4.2 million and commission expenses of $1.0 million related to Kintana employees who joined us as part of the acquisition. The increase was also attributable to an increase of $5.5 million in marketing programs to promote our BTO initiative through a number of campaigns, an increase of $2.9 million in allocated IT infrastructure expenses, a severance charge of $1.5 million, and an increase of $1.0 million in professional services. The severance charge of $1.5 million was related to accrued salaries and bonuses for a former executive officer. In December 2003, we entered into a severance agreement with a former executive officer. In accordance with the agreement, he is entitled to salary and bonus through October 3, 2005. We also modified terms of certain options granted to this former officer (see further discussion under stock-based compensation below). These increases were partially offset by a decrease of $0.9 million in allocated facility expenses due to a slight decrease in the headcount percentage in marketing and selling department relative to our total employees in fiscal 2003.

Marketing and selling expense was $193.8 million for the year ended December 31, 2002, or 48% of total revenues, compared to $182.7 million for the year ended December 31, 2001, or 51% of total revenues. The increase of $11.1 million was primarily attributable to an increase of $8.7 million in personnel-related costs due to an increased number of employees. This increase was also attributable to a $1.7 million increase in marketing programs due to the launch of our BTO initiative together with the cancellation of a marketing event in 2001, and a $0.7 million increase in allocated facilities related costs due to the addition of new offices. These costs were partially offset by a decrease of $0.7 million in allocated IT infrastructure expenses and a decrease of $0.7 million primarily related to referral fees costs previously netted against selling expenses, as well as a decrease of $0.6 million in commission expense due to changes made in our sales compensation plan in the beginning of 2002.

Research and development

Research and development expense is comprised of employee salaries and related costs, consulting costs, equipment depreciation and allocated facility and IT infrastructure expenses associated with the development of new products, enhancements of existing products, and quality assurance procedures. Research and development expense was $55.6 million for the year ended December 31, 2003, or 11% of total revenues, compared to $42.2

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million for the year ended December 31, 2002, or 11% of total revenues. The increase of $13.4 million was primarily attributable to an increase of $9.8 million in personnel-related costs due to an increased number of employees, of which $3.0 million was related to Kintana employees who joined us as part of the acquisition, an increase of $1.8 million in allocated facility expenses, and an increase of $1.7 million in allocated IT infrastructure expenses. The increase was also attributable to a $1.8 million devaluation of the U.S. dollar to the Israeli Shekel as a substantial portion of our research and development expenses were in Israeli Shekel. Based upon our product development plan, we expect research and development expense to continue to increase in absolute dollars in fiscal 2004.

Research and development expense was $42.2 million for the year ended December 31, 2002, or 11% of total revenues, compared to $40.7 million for the year ended December 31, 2001, or 11% of total revenues. The increase of $1.5 million was primarily attributable to an increase of $3.4 million in personnel-related costs due to an increased number of employees, an increase of $1.3 million in allocated facility expenses, and an increase of $0.8 million in allocated IT infrastructure expenses. These costs were partially offset by a $4.2 million devaluation of the Israeli Shekel to the U.S. dollar.

General and administrative

General and administrative expense consists of employee salaries and related costs associated with administration and management, as well as allocated facility and IT infrastructure expenses. General and administrative expense was $40.0 million for the year ended December 31, 2003, or 8% of total revenues, compared to $32.4 million for the year ended December 31, 2002, or 8% of total revenues. The increase of $7.6 million was primarily attributable to an increase of $5.8 million in personnel-related costs due to an increased number of employees, an increase of $1.2 million in professional services due to increased audit, tax and other consulting fees, and an increase of $0.9 million in allocated IT infrastructure expenses. We expect general and administrative expenses to continue to increase in absolute dollars in fiscal 2004.

General and administrative expense was $32.4 million for the year ended December 31, 2002, or 8% of total revenues, compared to $24.8 million for the year ended December 31, 2001, or 7% of total revenues. The absolute dollar increase of $7.6 million was primarily attributable to an increase of $3.5 million in personnel-related costs due to an increased number of employees, $1.3 million in professional services due to increased audit, tax and other related consulting, an increase of $0.7 million due to increased insurance expense, and an increase of $0.8 million in sales tax reserves. The increase was also due to an increase of $1.2 million in allocated IT infrastructure expenses.

Stock-based compensation

Stock-based compensation was $6.0 million for the year ended December 31, 2003 compared to $1.2 million for the year ended December 31, 2002. The increase of $4.8 million was primarily attributable to a one-time stock-based compensation charge related to a former executive officer. In December 2003, in connection with a severance agreement with a former executive officer, we extended the exercise period of options to purchase 350,000 shares of common stock and accelerated the vesting of options to purchase 374,479 shares of common stock at exercise prices ranging from $29.29 to $60.88. As a result of the modification of stock options, we recorded a stock-based compensation charge of $5.1 million based on the fair value of Mercury common stock on the date of the modification. In addition, we recorded amortization of unearned stock-based compensation totaling $0.2 million related to assumed options as a result of the acquisitions of Performant and Kintana in fiscal 2003. Amortization of unearned stock-based compensation related to assumed options from the acquisition Freshwater in 2001 was $0.6 million. Unearned stock-based compensation is amortized over the remaining vesting period of the related options on a straight-line basis. We expect to record amortization of unearned stock-based compensation of $0.8 million for 2004, $0.4 million for 2005, $0.3 million for 2006, and less than $0.1 million for 2007.

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Stock-based compensation was $1.2 million for the year ended December 31, 2002 compared to $2.0 million for the year ended December 31, 2001. The decrease of $0.8 million was primarily attributable to a reduction of unearned stock-based compensation due to the termination of certain employees in 2002. The decrease was partially offset by a full year of amortization of unearned stock-based compensation of $1.2 million in connection with the acquisition of Freshwater in May 2001. We also recorded a one-time stock-based compensation charge of $0.3 million in conjunction with the 2001 restructuring (see discussion regarding our restructuring activities under “Restructuring, integration and other related charges” below).

Acquisition related charges

Acquisition related charges of $12.0 million for the year ended December 31, 2003, or 2% of total revenues, were related to acquired in-process research and development from acquisitions during the year. In conjunction with the acquisitions of Performant in May 2003 and Kintana in August 2003, we recorded $1.3 million and $10.7 million, respectively, for acquired in-process research and development because technological feasibility had not been established and no future alternative uses existed upon the acquisitions. No in-process research and development was recorded in 2002 and 2001.

We engaged a third party to assist us in the preparation of a valuation of the assets we acquired in each of our business combinations, which we used to prepare the allocation of the purchase price. The fair value of in-process research and development was determined through the discounted cash flow approach using key assumptions for percentage of completion, future market demand, and product life cycle. Any differences between assumptions we used and actual results may have a material adverse impact on our business and operating results. Actual results from the purchase acquisitions to date did not have a material adverse impact on our business and operating results.

Also, see Note 5 to the consolidated financial statements for additional information regarding the acquisitions completed in 2003 and the in-process research and development recorded in each acquisition.

Restructuring, integration and other related charges

Restructuring, integration and other related charges were $3.4 million for the year ended December 31, 2003, or 1% of total revenues, compared to a benefit of $0.5 million for the year ended December 31, 2002. The increase of $3.9 million was primarily due to a charge of $2.8 million related to a milestone bonus plan signed in conjunction with the acquisition of Performant and integration costs of $0.6 million associated with the Kintana acquisition, primarily for employee severance and consulting services. In May 2003, in conjunction with the acquisition of Performant, we entered into a milestone bonus plan related to certain research and development activities. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates through November 2004. The commitment will be earned over time as milestones are achieved and expensed as “Restructuring, integration and other related charges” in our consolidated statement of operations. The maximum payments under the plan are $5.5 million. No integration costs were incurred in 2002 and 2001. The benefit of $0.5 million for the year ended December 31, 2002 was related to a reversal of cash charges associated with the cancellation of a marketing event for which we were able to use the deposit toward another event. We expect that all of the integration costs relating to the Kintana integration have been incurred and that there will be no additional integration costs in the future related to Kintana.

Restructuring, integration and other related charges were a benefit of $0.5 million for the year ended December 31, 2002, compared to a $5.4 million charge for the year ended December 31, 2001, or 1% of total revenues. During the second quarter of 2001, in conjunction with the acquisition of Freshwater, we recorded a charge for certain nonrecurring restructuring and integration costs of $0.9 million. The charge included costs for consolidation of facilities, employee severance, and fixed asset write-offs. As of June 30, 2002, all costs associated with the charge had been paid. During the third quarter of 2001, in connection with management’s plan to reduce costs and improve operating efficiencies, we recorded restructuring charges of $4.4 million,

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consisting of $2.9 million for employee reductions, $1.1 million for the cancellation of a marketing event, and $0.4 million for professional services and consolidation of facilities. Employee reductions consisted of approximately 140 employees, or 8% of our worldwide workforce. Total cash payments associated with the restructuring was $3.7 million as of March 31, 2002. During the first quarter of 2002, we reversed $0.5 million of the cash restructuring charges associated with the cancellation of the marketing event because we were able to use the deposit for another event. The remaining restructuring costs of $0.2 million consisted of non-cash charges for asset write-offs.

Amortization of goodwill and other intangible assets

In January 2002, we adopted Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, and as a result, we ceased to amortize approximately $111.8 million of goodwill and reclassified certain intangible assets to goodwill. We are also required to perform an impairment review of goodwill on an annual basis or more frequently if circumstances change. We did not record an impairment charge based on the results of our review in the fourth quarters of 2003 and 2002. Goodwill represents excess of purchase price over fair value of tangible and intangible assets acquired in an acquisition. Prior to 2002, goodwill was amortized on a straight-line basis over its useful life of 36 months, which best represented the distribution of the economic value of the goodwill. For the year ended December 31, 2001, amortization of goodwill and other intangible assets was $30.1 million. Amortization of goodwill in 2001 was $29.0 million or 8% of total revenues as a result of acquisition of Freshwater in May 2001 and amortization of other intangible assets in 2001 was $1.1 million.

Amortization of intangible assets was $7.5 million for the year ended December 31, 2003, or 1% of total revenues, compared to $2.4 million for the year ended December 31, 2002, or 1% of total revenues. The increase of $5.1 million was primarily attributable to acquisitions of Performant and Kintana in May 2003 and August 2003, respectively. Intangible assets acquired from Performant and Kintana were $3.4 million and $44.3 million, respectively. In July 2003, we purchased existing technology from Allerez for $1.3 million. In October 2003, we purchased the Mercury.com domain name for cash of $0.7 million and future services from us valued at approximately $0.4 million.

Amortization of intangible assets was $2.4 million for the year ended December 31, 2002, or 1% of total revenues, compared to $1.1 million for the year ended December 31, 2001, or less than 1% of total revenues. The increase of $1.3 million was primarily attributable to full year amortization of intangible assets from the acquisition of Freshwater in May 2001.

We engaged a third party to assist us in the preparation of valuation of the intangible assets acquired from Allerez, Kintana, Performant, and Freshwater. The intangible assets are amortized on a straight-line basis over their useful lives or based on actual usage; whichever best represents the distribution of the economic value of the intangible assets. The estimated total amortization expense associated with our intangible assets is $14.6 million for 2004, $13.5 million for 2005, $10.0 million for 2006, $3.8 million for 2007, $2.6 million for 2008, and $0.6 million thereafter.

Also, see Notes 5 and 6 to the consolidated financial statements for additional information regarding the acquisitions completed in 2003 and 2001 and the intangible assets acquired in each acquisition.

Facilities impairment

In July 2003, the Board of Directors approved a plan to lease a new headquarter facility and to sell the existing buildings in our Sunnyvale headquarters. During September 2003, we signed a letter of intent to lease four buildings and material terms of the lease were finalized in the same month. The lease agreement was signed in October 2003. As a result of our decision to move to a new headquarter facility and to sell the buildings we vacated and plan to vacate, we performed an impairment analysis of the four buildings that comprise our Sunnyvale headquarters. In September 2003, we wrote down the net book value of our two existing vacant buildings to $2.7 million, which approximated their appraised market value after taking into account the cost to

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maintain these facilities until sold and sales commissions related to the sale of the buildings. Accordingly, we reclassified these two buildings as assets held for sale. Assets held for sale are included in “Prepaid expenses and other assets” in our consolidated balance sheet as of December 31, 2003. The impairment charge of $16.9 million associated with the write-down is reflected in our consolidated statement of operations for the year ended December 31, 2003. On January 30, 2004, the two vacant buildings were sold at the carrying value to a third party for $2.7 million in cash. We are currently using the remaining two buildings as our new headquarter facility is not available for us to occupy until the second quarter of fiscal 2004. We have not recorded any impairment charges related to these buildings. We may record additional impairment charges on the remaining existing facilities in the future based on the appraised market value at the time of vacancy and/or sale.

Other income, net

Interest income

Interest income was $34.7 million for year ended December 31, 2003, or 6% of total revenues, compared to $35.1 million for the year ended December 31, 2002, or 9% of total revenues. The decrease of $0.4 million was primarily attributable to a decline in interest rates in 2003 and a reduction of interest income associated with our February 2002 interest rate swap, which was included in interest income until the January and February 2002 swaps were merged into one in November 2002.

Interest income was $35.1 million for the year ended December 31, 2002, of 9% of total revenues, compared to $37.0 million for the year ended December 31, 2001, or 10% of total revenues. The decrease of $1.9 million was primarily attributable to a reduction of $16.3 million in interest income due to lower interest rates, offset by an increase in interest income of $14.4 million, primarily from two interest rate swaps we entered into in January and February 2002. These two interest rate swaps were merged into one in November 2002.

Interest expense

Interest expense was $19.6 million for the year ended December 31, 2003, or 4% of total revenues, compared to $23.4 million for the year ended December 31, 2002, or 6% of total revenues. The decrease of $3.8 million was primarily attributable to a decrease of $2.6 million in interest expense associated with our interest rate swap due to lower London Interbank Offering Rate (LIBOR) and a change in the interest rate spread between the January 2002 swap and the November 2002 swap. The decrease was also attributable to a full year interest expense of $1.2 million associated with the portion of our Convertible Subordinated Notes issued in 2000 (2000 Notes) that was early retired in 2002.

Interest expense was $23.4 million for the year ended December 31, 2002, or 6% of total revenues, compared to $23.6 million for the year ended December 31, 2001, or 7% of total revenues. The decrease of $0.2 million was primarily attributable to a decrease of $8.1 million in interest expense associated with a partial retirement of our 2000 Notes, offset by interest expense of $7.9 million associated with the two interest rate swaps we entered into in January and February 2002. We merged these two interest rate swaps into one in November 2002. From December 2001 through June 30, 2002, we retired $200.0 million face value of our 2000 Notes. We did not retire any 2000 Notes during the last six months of 2002. As a result of the partial retirement, our interest expense resulting from our 2000 Notes decreased during 2002.

We entered into interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) in order to hedge the change in the fair value attributable to the LIBOR of $300.0 million of our 2000 Notes. In January 2002 and February 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. These two swaps were merged into one in November 2002. The objective of the swap is to convert the 4.75% fixed interest rate on our 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The November 2002 swap qualifies for hedge accounting treatment in accordance with Statement of Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, and the related amendment.

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Also, see Note 7 and 12 to the consolidated financial statements for additional information regarding our 2000 Notes and the related interest rate swap activities.

Net loss on investments in non-consolidated companies

Net loss on investments in non-consolidated companies was $3.5 million for the year ended December 31, 2003, or 1% of total revenues, compared to $5.3 million for the year ended December 31, 2002, or 1% of total revenues. For the year ended December 31, 2003, we recorded losses of $3.5 million on three of our investments in early stage private companies and a loss of $0.4 million on our investment in a private equity fund. These losses were partially offset by an unrealized gain of $0.4 million related to a change in fair value of a warrant to purchase common stock of Motive, Inc. For the year ended December 31, 2002, we recorded losses of $5.3 million on three of our investments in early stage private companies.

The fair value of the Motive warrant was calculated by using the Black-Scholes option-pricing model, which requires subjective assumptions including the expected stock price volatility and stock price of the company. In calculating the loss to be recorded on our investments in early stage private companies and private equity funds, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to outside third party investors.

Other income (expense), net

Other expense, net was $2.5 million for the year ended December 31, 2003, or less than 1% of total revenues, compared to other income, net of $8.0 million for the year ended December 31, 2002, or 1% of total revenues. The decrease in other income, net of $10.5 million was primarily attributable to a reduction of $11.6 million on gains on early retirement of our 2000 Notes and an increase of $1.6 million in amortization of debt issuance costs associated with the issuance of our 2003 Notes. These decreases in other income, net were partially offset by a decrease of $1.7 million in foreign exchange losses due to a devaluation of the U.S. dollar resulting in gains from our forward contracts and an increase of $1.4 million in interest income associated with notes receivable from issuance of common stock to foreign employees under our stock option plans.

Other income, net was $8.0 million for the year ended December 31, 2002, or 1% of total revenues, compared to other income, net of $17.1 million for the year ended December 31, 2001, or 5% of total revenues. The decrease of $9.1 million was primarily attributable to a reduction of $8.2 million on gains on early retirement of our 2000 Notes and an increase of foreign exchange losses of $1.7 million, partially offset by a reduction of debt issuance cost amortization of $0.5 million due to early retirement of a portion of our 2000 Notes.

Also, see Note 12 to the consolidated financial statements for additional information regarding the forward exchange contracts.

Provision for income taxes

Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investments. The tax holidays and rate reductions, which we will be able to realize under programs currently in effect, expire at various dates through 2013. Future provisions for taxes will depend upon the mix of worldwide income and the tax rates in effect for various tax jurisdictions. The effective tax rate for the years ended December 31, 2003, 2002, and 2001 differ from statutory tax rates principally because of our participation in taxation programs in Israel. We intend to continue to increase our investment in our Israeli operations consistent with our overall tax strategy. Other factors that cause the effective tax rate and statutory tax rates to differ include the non-deductibility of charges for amortization of intangible assets, stock-based compensation, and in-process research and development. U.S. income taxes and foreign withholding taxes were not provided for on undistributed earnings for certain non-U.S. subsidiaries. We intend to invest these earnings indefinitely in operations outside the U.S.

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In 2002, we sold the economic rights of Freshwater’s intellectual property to our Israeli subsidiary. As a result of this intellectual property sale, we have recorded a current tax payable and a prepaid tax asset in the amount of $25.5 million, which is being amortized to income tax expense in our consolidated statements of operations over eight years, which approximates the period over which the expected benefit is expected to be realized. We intend to migrate the economic ownership of the technology acquired from Performant and Kintana to our Israeli subsidiary in fiscal 2004, which may lead to a temporary increase in the effective tax rate. At December 31, 2003, we have a prepaid tax asset of $3.2 million included in “Prepaid expenses and other assets” and $15.9 million included in “Other assets, net” in our consolidated balance sheet.

Liquidity and Capital Resources

At December 31, 2003, our principal source of liquidity consisted of $1.2 billion of cash and investments, compared to $665.2 million and $588.9 million at December 31, 2002 and 2001, respectively. The December 31, 2003 balance included $157.1 million of short-term and $527.3 million of long-term investments in high quality financial, government, and corporate securities, compared to $178.1 million and $179.5 million of short-term and $138.0 million and $161.1 million of long-term investments in high quality financial, government, and corporate securities in the December 31, 2002 and 2001 balances, respectively. The increase in cash and investments from December 31, 2002 was primarily due to positive cash generated from operations, issuance of our 2003 Notes, and cash received from issuance of common stock under our stock option and employee stock purchase plans, partially offset by cash used in capital expenditures and acquisitions of business and technology. During the year ended December 31, 2003, we generated $180.5 million of cash from operating activities, compared to $132.2 million during the year ended December 31, 2002. The increase in cash from operations during fiscal 2003, compared to fiscal 2002, was due primarily to a larger increase in the deferred revenue balance as we continue to offer more products on a subscription basis and more customers license our products on a subscription basis.

During the year ended December 31, 2003, we used $547.2 million in investing activities, compared to $8.1 million cash provided by our investing activities in the year ended December 31, 2002. The increase in cash used in our investing activities was partially related to net cash used in the acquisitions of Performant for $22.0 million, Kintana for $136.7 million, and Allerez technology for $1.3 million. The acquisitions of Performant and Kintana expand our product lines offered to our customers and technology acquired from Allerez extends the functionality of our application delivery and application management products. Cash was also used in the purchase of investments for $368.0 million, and capital expenditures of $17.1 million to support our expanded business. The increase was partially offset by a reduction of equity investments in non-consolidated companies and no additional restricted cash was required to be delivered under our interest rate swap with GSCM, as was required in fiscal 2002.

During the year ended December 31, 2003, cash proceeds from our financing activities were $567.0 million, compared to cash used in our financing activities of $40.7 million in the year ended December 31, 2002. The increase in cash proceeds from our financing activities was primarily due to issuance of our 2003 Notes in April 2003, an increase in issuance of common stock under our employee stock option and stock purchase plans, collection of notes receivable from issuance of common stock, and no retirement of our 2000 Notes in fiscal 2003. Cash proceeds from issuance of the 2003 Notes, net of issuance costs of $11.9 million, was $488.1 million.

In June 2003, we entered into a non-exclusive agreement to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out, or other transfer of all or substantially all of the business, stock or assets to which the agreement relates. The licensed technology will be combined with our other existing products, which should be generally available within twelve months from the effective date of this agreement. The agreement was originally in effect until December 31, 2005 with an election to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. In February 2004, the agreement was extended to December 31, 2006. In accordance with the addendum, we will pay an additional $0.4 million to Motive for an additional 12-month maintenance and support service for the year ending December 31, 2006. The fee is due on December 31, 2005. In addition, the addendum accelerated the payment of

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the remaining royalty balance of $7.0 million. Under the original agreement, we had committed to royalty payments totaling $15.0 million, of which $8.0 million had been paid as of December 31, 2003. The remaining balance of $7.0 million was paid in February 2004.

As of December 31, 2003, we are committed to make additional capital contributions to a private equity fund totaling $8.6 million.

As of December 31, 2003, we had four irrevocable letter of credit agreements totaling $1.4 million with Wells Fargo & Company (Wells Fargo) in conjunction with our facility leases. Wells Fargo is a related party of Mercury as one of the members of our Board of Directors is an executive officer of Wells Fargo. These agreements are primarily related to facility leases assumed by us in conjunction with the acquisitions of Kintana and Freshwater and the facility lease for our new headquarters in Mountain View, California. Two of the agreements have automatic annual renewal provisions under which the expiration dates cannot be extended beyond March 1, 2006 and August 31, 2006. The agreement for the facility lease of our new headquarters automatically renews annually after January 1, 2005 unless Mercury provides a termination notice to Wells Fargo. The fourth agreement expires in September 2004. As of December 31, 2003, no letters of credit were drawn.

We lease facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. In addition, we lease certain equipment under various leases with lease terms ranging from month-to-month up to one year.

Future payments due under debt and lease obligations at December 31, 2003 are as follows (in thousands):

	Zero Coupon Senior Convertible Notes due 2008 (2003 Notes)		4.75% Convertible Subordinated Notes due 2007 (2000 Notes) (a)		Non- Cancelable Operating Leases		Royalty Agreements		Total
2004	$	—	$	—	$	16,270	$	7,020	$	23,290
2005		—		—		14,840		10		14,850
2006		—		—		9,823		10		9,833
2007		—		300,000		7,080		10		307,090
2008		500,000		—		5,786		10		505,796
Thereafter		—		—		24,897		100		24,997
Total	$	500,000	$	300,000	$	78,696	$	7,160	$	885,856

(a) Assuming we do not retire additional 2000 Notes during 2004 and interest rates stay consistent, we will make interest payments net of our interest rate swap of approximately $4.8 million during each of 2004, 2005, and 2006, and approximately $2.4 million during 2007. The face value of our 2000 Notes differs from our book value. See Note 7 to the consolidated financial statements for a full description of our long-term debt activities and related accounting policies.

In July 2000, we issued $500.0 million in Subordinated Convertible Notes due on July 1, 2007. The 2000 Notes bear interest at a rate of 4.75% per annum and are payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. The entire outstanding principal amount of the 2000 Notes will become due and payable at maturity. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. Accrued interest to the redemption date will be paid by us in any such redemption. From December 2001 through June 30, 2002, we retired $200.0 million face value of the 2000 Notes.

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In April 2003, in a private offering we issued $500.0 million of Zero Coupon Convertible Notes due on May 1, 2008. The 2003 Notes do not bear interest, have a zero yield to maturity and may be convertible into our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only if the sale price of our common stock reaches specified thresholds or if specified corporate transactions have occurred. Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity. See Note 7 to the consolidated financial statements for further details on the conversion provisions for the 2003 Notes.

Historically, a significant amount of our income and cash flow was generated in Israel where tax rate incentives have been extended to encourage foreign investment. We may have to pay significantly more income taxes if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased or if we choose to repatriate cash balances from Israel to other foreign jurisdictions. In addition, our future tax provisions will depend on the mix of our worldwide income and the tax rates in effect for various tax jurisdictions.

As of December 31, 2003, we did not have any purchase commitments other than obligations incurred in the normal course of business. These amounts are accrued when services or goods are received.

For the years ended December 31, 2003, 2002, and 2001, our source of funding was mainly from cash generated by our operations and from the issuance of convertible notes. Since our operating results may fluctuate significantly, a decrease in customer demand or a decrease in the acceptance of our future products and services may impact our ability to generate positive cash flow from operations.

In 2002, we changed the mix of software license types to a higher percentage of subscription licenses. The amount of application delivery products licensed on a subscription basis continues to increase since the change in 2002. In addition, we continue to derive a substantial portion of our overall business growth through the growth of our application management product offerings which are primarily offered on a subscription basis. This shift in the mix of license types does not impact our collections cycle as we typically invoice the customers up front for the full license amount and cash is generally received within 30-60 days from the invoice date in the U.S. (slightly longer in EMEA). Our quarterly operating results are affected by the mix of license types entered into in connection with the sale of products. As revenue associated with our subscription licenses is generally recognized ratably over the term of the license, the shift in mix will also result in deferred revenue becoming a larger component of our cash provided by operations. We believe that the shift to a subscription revenue model will continue in the future as we offer more products on a subscription basis and as more of our customers license our products on a subscription basis. This shift may cause us to experience a decrease or a lower rate of growth in recognized revenue, as well as continued growth in deferred revenue. Deferred revenue as of December 31, 2003 was $280.6 million compared to $159.4 million as of December 31, 2002, primarily due to an increase in subscription licenses.

In the future, we expect cash will continue to be generated from our operations. We expect to spend additional cash of approximately $9.4 million on leasehold improvements and IT infrastructure for our new leased campus, and other related costs during fiscal 2004. We do not expect the level of cash used in investing activities to acquire property and equipment in 2004 to change significantly from fiscal 2003. In February 2004, we purchased approximately 30,000 square feet of land for $2.3 million near our existing offices in Israel, which will be used for our research and development activities there. We currently plan to reinvest our cash generated from operations in new short- and long-term investments in high quality financial, government, and corporate securities or other investments, consistent with past investment practices, and therefore net cash used in investing activities may increase. Cash could be used in the future to invest in acquisitions, strategic investments, or repurchase additional debt or equity. There are no transactions, arrangements, or other relationships with non-consolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of our requirements for capital resources.

Assuming there is no significant change in our business, we believe that our current cash and investment balances and cash flow from operations will be sufficient to fund our cash needs for at least the next twelve months.

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Critical Accounting Policies

The methods, estimates, and judgments we use in applying our most critical accounting policies have a significant impact on the results we report in our consolidated financial statements. The Securities and Exchange Commission has defined the most critical accounting policies as the ones that are most important to the portrayal of our financial condition and results, and require us to make our most difficult and subjective judgments, often as a result of the need to make estimates of matters that are inherently uncertain.

Our critical accounting policies are as follows:

• revenue recognition;

• estimating valuation allowances and accrued liabilities;

• valuation of long-lived assets and other intangible assets;

• valuation of goodwill;

• accounting for income taxes;

• accounting for investments in non-consolidated companies;

• accounting for stock options; and

• estimating of forward contract terms.

We discuss these policies further, as well as the estimates and judgments involved. We also have other key accounting policies. We believe that these other policies either do not generally require us to make estimates and judgments that are as difficult or as subjective, or it is less likely that they would have a material impact on our reported results of operations for a given period.

Revenue recognition

Our revenue recognition policy is detailed in Note 1 to the consolidated financial statements. We have made significant judgments related to revenue recognition; specifically, in connection with each transaction involving our arrangements, we must evaluate whether our fee is “fixed or determinable” and we must assess whether “collectibility is probable.” These judgments are discussed below.

Fee is fixed or determinable

With respect to each arrangement, we must make a judgment as to whether the arrangement fee is fixed or determinable. If the fee is fixed or determinable, then revenue is recognized upon delivery of software or over the period of arrangements with our customers (assuming other revenue recognition criteria are met). If the fee is not fixed or determinable, then the revenue recognized in each quarter (subject to application of other revenue recognition criteria) will be the lesser of the aggregate of amounts due and payable or the amount of the arrangement fee that would have been recognized if the fees had been fixed or determinable.

A determination that an arrangement fee is fixed or determinable also depends upon the payment terms relating to such an arrangement. Our customary payment terms are generally within 30-60 days of the invoice date, depending upon the region. Arrangements with payment terms extending beyond the customary payment terms are considered not to be fixed or determinable. A determination of whether the arrangement fee is fixed or determinable is particularly relevant to revenue recognition on perpetual licenses. The amount and timing of our revenue recognized in any period may differ materially if we make different judgments.

Collectibility is probable

In order to recognize revenue, we must make a judgment of the collectibility of the arrangement fee. Our judgment of the collectibility is applied on a customer-by-customer basis. We generally sell to customers for

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which there is a history of successful collection. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. The amount and timing of revenue recognized in any period may differ materially if we make different judgments.

Estimating valuation allowances and accrued liabilities

The preparation of financial statements requires us to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Use of estimates and assumptions include, but are not limited to, the sales reserve and prepaid commissions.

We must make estimates of potential future credits, warranty cost of product and services, and write-off of bad debts related to current period product revenues. We analyze historical returns, historical bad debts, current economic trends, average deal size, and changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserves. Revenue for the period is reduced to reflect the sales reserve provision. As a percentage of current period revenues, charges against sales reserves were insignificant in the years ended December 31, 2003, 2002, and 2001. Significant management judgments and estimates are made and used in connection with establishing the sales reserve in any accounting period. Material differences may result in the amount and timing of our revenues for any period if we make different judgments or use different estimates. At December 31, 2003 and 2002, the provisions for sales reserves were $6.1 million and $7.4 million, respectively.

We are required to make estimates of the future sales commission expense associated with our revenues that will be recognized in future periods. We analyze historical commission rates, composition of the future revenues and expected timing of revenue recognition of such future amounts. We make significant judgments and estimates in connection with establishing the prepaid commission in any accounting period. Material differences may result in the amount and timing of our sales commission expense for any period if we make different judgments or use different estimates. At December 31, 2003 and 2002, prepaid commissions were $23.4 million and $13.6 million, respectively.

Valuation of long-lived assets and other intangible assets

We assess the impairment of long-lived assets and certain identifiable intangible assets to be held and used whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

• a significant decrease in the market price of a long-lived asset (asset group);

• a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;

• a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;

• an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group);

• a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); and

• a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

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We determine the recoverability of long-lived assets and certain identifiable intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Such estimation process is highly subjective and involves significant management judgment. Determination of impairment loss for long-lived assets and certain identifiable intangible assets that management expects to hold and use is based on the fair value of the asset. Long-lived assets and certain identifiable intangible assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. During the year ended December 31, 2003, we recorded an impairment charge of $16.9 million associated with our two vacant headquarters buildings. During the years ended December 31, 2002 and 2001, we did not record any impairment charges on long-lived assets or certain intangible assets. If our estimates or the related assumptions change in the future, we may be required to record an impairment charge on long-lived assets and certain intangible assets to reduce the carrying amount of these assets. Net intangible assets and long-lived assets were $118.3 million and $91.1 million at December 31, 2003 and 2002, respectively.

Valuation of goodwill

We assess the impairment of goodwill on an annual basis, and potentially more frequently if events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

• significant underperformance relative to expected historical or projected future operating results;

• significant changes in the manner of our use of the acquired assets or the strategy for our overall business;

• significant negative industry or economic trends;

• significant decline in our stock price for a sustained period; and

• our market capitalization relative to net book value.

When we determine that the carrying value of goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure this impairment based on a projected discounted cash flow. We completed the preliminary assessment during the first quarter of 2002 and performed an annual impairment review during the fourth quarter in both 2003 and 2002. We did not record an impairment charge based on our reviews. If our estimates or the related assumptions change in the future, we may be required to record impairment charge on goodwill to reduce its carrying amount to its estimated fair value.

During the fourth quarter of 2002, upon further review of SFAS No. 142, we reclassified $1.2 million of net intangible assets to goodwill. We had previously amortized goodwill of $0.2 million associated with these intangible assets in each of the first three quarters of 2002. We did not amortize this amount during the fourth quarter of 2002 and have ceased amortization associated with these intangible assets. Goodwill was $347.6 million and $113.3 million at December 31, 2003 and 2002, respectively.

Accounting for income taxes

As part of the process of preparing our consolidated financial statements, we are required to estimate our income tax expense in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheets. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future. Our taxes could increase if these tax rate incentives are not renewed upon expiration, tax rates applicable to us are increased, authorities challenge our tax strategy, or our tax strategy is impacted by new laws or rulings.

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Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities, and any valuation allowance recorded against our net deferred tax assets. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options. In the event that actual results differ from these estimates or we adjust these estimates in future periods, we may need to establish an additional valuation allowance, which could materially impact our financial position and results of operations.

Accounting for investments in non-consolidated companies

From time to time, we make investments in early stage private companies and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as we do not have the ability to exercise significant influence over these companies’ operations. We periodically monitor our investments for impairment and will record reductions in carrying values if and when necessary. The evaluation process is based on information that we request from these privately-held companies and private equity funds. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing based on a valuation significantly lower than the carrying value of our investment and the decline is other than temporary, it is our policy to record an investment loss in our consolidated statements of operations. Estimating the fair value of non-marketable equity investments in early-stage technology companies is inherently subjective and may contribute to significant volatility in our reported results of operations.

At December 31, 2003, our investments in non-consolidated companies was $13.9 million. Our investments in early stage private companies and a private equity fund were $13.5 million. We have committed to make capital contributions to this private equity fund for $15.0 million. As of December 31, 2003, our total capital contributions to this private equity fund were $6.4 million. Our investments also include the fair value of a warrant to purchase common stock of Motive was $0.4 million. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. The potential decline in the NASDAQ National Market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million, and $0.5 million on three of our investments in early stage private companies and a loss of $0.4 million on our investment in the private equity fund. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million, and $0.4 million on three of our investments in early stage private companies. For the year ended December 31, 2001, we did not record any losses on our investments in early stage private companies and the private equity fund. In calculating the loss to be recorded, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to outside third party investors.

We hold a warrant to purchase common stock of Motive. The warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting period. We calculate the fair value of the warrant using the Black-Scholes option-pricing model. The option-pricing model requires the input of highly subjective assumptions such as the expected stock price volatility and stock price. In determining the stock price volatility, we consider volatility rates of other publicly trade companies in the same industry with comparable revenues. We also take into account the latest option grant price when determining the stock price for the option-pricing assumptions. Estimating the fair value of derivative instruments issued by a private company requires management judgment and may contribute to volatility in our reported results of operations.

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Accounting for stock options

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of Statement of Financial Accounting Standard (SFAS) No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise price. No stock-based compensation was recorded for stock options granted to our employees because we have granted stock options to our employees equal to the market price of the underlying stock on the date of grant.

In 2001 and 2003, we recorded unearned stock-based compensation primarily due to assumed stock options in conjunction with our acquisitions of Freshwater, Performant, and Kintana. We amortize unearned stock-based compensation using the straight-line method over the remaining vesting periods of the related options. If we amortize unearned stock-based compensation using the graded vesting method, which results in higher expense being recognized in the earlier period, our financial position and results of operations could be different.

In the 2003 Annual Meeting of the Stockholders held in May 2003, a proposal requesting our Board of Directors establish a policy of expensing stock options was put on the ballot by one of our stockholders. The stockholders voted for the proposal and our Board of Directors is currently reviewing this matter.

In addition, the Financial Accounting Standards Board (FASB) is currently conducting a project on the accounting for equity-based compensation. If the current project becomes final, companies will be required to value employee stock options and stock issued under employee stock purchase plans using the fair value method on the grant date and record stock-based compensation expense accordingly. The fair value models that companies are allowed to use could be different from the Black-Scholes option-pricing model, which is currently used by us to calculate the pro forma effect on net income and earnings per share if we had applied SFAS 123 to employee option grants. See Note 1 to our consolidated financial statements for the disclosure of the pro forma net income and earnings per share for the years ended December 31, 2003, 2002, and 2001 if we had applied SFAS 123. However, the actual impact to our results of operations upon adoption of the potential new accounting rule could be materially different from the pro forma information included in Note 1 to our consolidated financial statements due to differences in the option-pricing model used, estimates and assumptions required, and options to be included in the calculation upon adoption. The fair value models require the input of highly subjective assumptions and do not necessarily provide a reliable single measure of the fair value of our stock options. We will closely monitor the development of this project and will evaluate the impact to our financial position and results of operations at such time that final rules are issued.

Estimating of forward contract terms

To mitigate our exposure on foreign currencies fluctuations, we have entered into forward contracts to hedge foreign currency denominated deferred revenues and receivables due from certain Americas, EMEA, APAC, and Japan subsidiaries and foreign branches against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. We enter into forward contracts based on our estimation of when revenue will be earned and cash will be collected. If the timing between when revenue is earned and cash is collected is different from our estimates, we will recognize gains or losses on forward contracts as a result of our hedging ineffectiveness. Based on any gains and losses our financial position and results of operations may be significantly impacted.

Recent Accounting Pronouncements

In January 2003, the FASB issued Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51, which relates to the identification of, and

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financial reporting for, variable-interest entities (VIEs). FIN No. 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. For those arrangements entered into prior to February 1, 2003, the provisions of FIN No. 46 are required to be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. In December 2003, FASB issued a revised FIN No. 46. The FASB deferred the effective date for VIEs that are non-special purpose entities created before February 1, 2003, to the first interim or annual reporting period that ends after March 15, 2004. We do not believe the adoption of FIN No. 46 will have a material impact on our financial position and results of operations.

Risk Factors

In addition to the other information included in this Annual Report on Form 10-K, you should carefully consider the risks described below before deciding to invest in us or maintain or increase your investment. The risks and uncertainties described below are not the only ones that we face. Additional risks and uncertainties not presently known to us or that we currently deem not significant may also affect our business operations. If any of these risks actually occur, our business, financial condition, or results of operations could be seriously harmed. In that event, the market price of our common stock could decline and you may lose all or part of your investment.

Our future success may be impaired and our operating results will suffer if we cannot respond to rapid market and technological changes by introducing new products and services and continually improving the performance, features, and reliability of our existing products and services and responding to competitive offerings.    The market for our software products and services is characterized by:

• rapidly changing technology;

• frequent introduction of new products and services and enhancements to existing products and services by our competitors;

• increasing complexity and interdependence of our applications;

• changes in industry standards and practices;

• ability to attract and retain key personnel; and

• changes in customer requirements and demands.

To maintain our competitive position, we must continue to enhance our existing products, like our software products and services for our application management and application delivery, and IT governance solutions. We must also continue to develop new products and services, functionality, and technology that address the increasingly sophisticated and varied needs of our prospective customers. The development of new products and services, and enhancement of existing products and services, entail significant technical and business risks and require substantial lead-time and significant investments in product development. In addition, many of the markets in which we operate are seasonal. If we fail to anticipate new technology developments, customer requirements or industry standards, or if we are unable to develop new products and services that adequately address these new developments, requirements, and standards in a timely manner, our products and services may become obsolete, our ability to compete may be impaired, our revenue would decline, and our operating results would suffer.

We expect our quarterly revenue and operating results to fluctuate, and it is difficult to predict our future revenue and operating results.    Our revenue and operating results have varied in the past and are likely to vary significantly from quarter to quarter in the future. These fluctuations are due to a number of factors, many of which are outside of our control, including:

• fluctuations in demand for, and sales of, our products and services;

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• our success in developing and introducing new products and services and the timing of new product and service introductions;

• our ability to introduce enhancements to our existing products and services in a timely manner;

• changes in economic conditions affecting our customers or our industry;

• changes in the mix of products or services sold in a quarter;

• changes in the mix of perpetual, term, or subscription licenses sold in a quarter;

• fluctuations in the number of large orders in a quarter;

• uncertainties related to the integration of products, services, employees, and operations of acquired companies;

• the introduction of new or enhanced products and services by our competitors and changes in the pricing policies of these competitors;

• the discretionary nature of our customers’ purchase and budget cycles and changes in their budgets for software and related purchases;

• the amount and timing of operating costs and capital expenditures relating to the expansion of our business;

• deferrals by our customers of orders in anticipation of new products or services or product enhancements; and

• the mix of our domestic and international sales, together with fluctuations in foreign currency exchange rates.

In addition, the timing of our software product revenues is difficult to predict and can vary substantially from product to product and customer to customer. We base our operating expenses on our expectations regarding future revenue levels. The timing of larger orders and customer buying patterns are difficult to forecast, therefore we may not learn of shortfalls in revenue or earnings or other failures to meet market expectations until late in a particular quarter. As a result, if total revenues for a particular quarter are below our expectations, we would not be able to proportionately reduce operating expenses for that quarter.

We have experienced seasonality in our orders and revenues which may result in seasonality in our earnings. The fourth quarter of the year typically has the highest orders and revenues for the year and higher orders and revenues than the first quarter of the following year. We believe that this seasonality results primarily from the budgeting cycles of our customers being typically higher in the third and fourth fiscal quarters, from our application management business being typically strongest in the fourth fiscal quarter and weakest in the first fiscal quarter, and to a lesser extent, from the structure of our sales commission program. We expect this seasonality to continue in the future.

Due to these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. If our operating results are below the expectations of investors or securities analysts, the trading prices of our securities could decline.

Our revenue targets are dependent on a projected mix of orders in a particular quarter and any failure to achieve revenue targets because of a shift in the mix of orders could adversely affect our quarterly revenue and operating results.    Our license revenue in any given quarter is dependent upon the volume of perpetual orders shipped during the quarter and the amount of subscription revenue amortized from deferred revenue and, to a small degree, the amount recognized on subscription orders received during the quarter. We set our revenue targets for any given period based, in part, upon an assumption that we will achieve a certain level of orders and a certain license mix of perpetual licenses and subscription licenses. The precise mix of orders is subject to

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substantial fluctuation in any given quarter or multiple quarter periods, and the actual mix of licenses sold affects the revenue we recognize in the period. If we achieve the target level of total orders but are unable to achieve our target license mix, we may not meet our revenue targets (if we deliver more-than-expected subscription licenses) or may exceed them (if we deliver more-than-expected perpetual licenses). In addition, if we achieve the target license mix but the overall level of orders is below the target level, then we will not meet our revenue targets which will adversely affect our operating results. In 2002, we began to effect a change in the mix of software license types to a higher percentage of subscription licenses in our application management and application delivery products. We believe that this shift will continue in the future as we offer more products on a subscription basis and more of our customers license our products on a subscription basis. This shift may cause us to experience a decrease in recognized revenue, as well as continued growth of deferred revenue. In addition, while subscription licenses represent a potential source of renewable license revenue, there is also the risk that customers will not renew their licenses at the end of a term.

Economic, political, and market conditions may adversely affect demand for our products and services.    Our customers’ decisions to purchase our products and services are discretionary and subject to their internal budgets and purchasing processes. We believe that the slowdown in the economy and the weakening of business conditions have caused and may continue to cause customers to reassess their immediate technology needs, lengthen their purchasing decision-making processes, require more senior level internal approvals of purchases, and defer purchasing decisions, and accordingly, have reduced and could reduce demand in the future for our products and services. In addition, the war on terrorism and the potential for other hostilities in various parts of the world have caused political uncertainties and volatility in the financial markets. Under these circumstances, there is a risk that our existing and potential customers may decrease spending for our products and services. If demand for our products and services is reduced, our revenue growth rates and operating results will be adversely affected.

We expect to face increasing competition in the future, which could cause reduced sales levels and result in price reductions, reduced gross margins, or loss of market share.    The market for our business technology optimization products and services is extremely competitive, dynamic, and subject to frequent technological change. There are few substantial barriers of entry in our market. The Internet has further reduced these barriers of entry, allowing other companies to compete with us in our markets. As a result of the increased competition, our success will depend, in large part, on our ability to identify and respond to the needs of current and potential customers, and to new technological and market opportunities, before our competitors identify and respond to these needs and opportunities. We may fail to respond quickly enough to these needs and opportunities.

In the market for application delivery solutions, our principal competitors include Compuware, Empirix, IBM Software Group, and Segue Software. In the new and rapidly changing market for application management solutions, our principal competitors include established providers of systems and network management software such as BMC Software, Computer Associates, HP OpenView (a division of Hewlett-Packard), and Tivoli (a division of IBM), and providers of managed services such as Keynote Systems. Additionally, we face potential competition in this market from existing providers of application delivery solutions such as Segue Software and Compuware. In the market of IT governance solutions, our principal competitors include enterprise application vendors such as SAP, PeopleSoft, Oracle, and Lawson, as well as point tool vendors such as Primavera and Niku.

We believe that the principal competitive factors affecting our market are:

• price and cost effectiveness;

• product functionality;

• product performance, including scalability and reliability;

• quality of support and service;

• company reputation;

• depth and breadth of BTO offerings;

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• R&D leadership;

• financial stability; and

• global capabilities.

Although we believe that our products and services currently compete favorably with respect to these factors, the markets for application management, application delivery, and IT governance are new and rapidly evolving. We may not be able to maintain our competitive position, which could lead to a decrease in our revenues and adversely affect our operating results. The software industry is increasingly experiencing consolidation and this could increase the resources available to our competitors and the scope of their product offerings. For example, our former application delivery competitor Rational Software was acquired by IBM Software Group, which has substantially greater financial and other resources than we have. Our competitors and potential competitors may develop more advanced technology, undertake more extensive marketing campaigns, adopt more aggressive pricing policies, or make more attractive offers to distribution partners and to employees.

If we fail to maintain our existing distribution channels and develop additional channels in the future, our revenue could decline.    We derive a portion of our business from sales of our products and services through distribution channels, such as global software vendors, systems integrators, or value-added resellers. We generally expect that sales of our products through these channels will continue to account for a substantial portion of our revenue for the foreseeable future. We may not experience increased revenue from new channels and may see a decrease from our existing channels, which could harm our business.

The loss of one or more of our systems integrators or value-added resellers, or any reduction or delay in their sales of our products and services could result in reductions in our revenue in future periods. In addition, our ability to increase our revenue in the future depends on our ability to expand our indirect distribution channels.

Our dependence on indirect distribution channels presents a number of risks, including:

• each of our global software vendors, systems integrators or value-added resellers can cease marketing our products and services with limited or no notice and with little or no penalty;

• our existing global software vendors, systems integrators, or value-added resellers may not be able to effectively sell any new products and services that we may introduce;

• we may not be able to replace existing or recruit additional global software vendors, systems integrators or value-added resellers, if we lose any of our existing ones;

• our global software vendors, systems integrators or value-added resellers may also offer competitive products and services;

• we may face conflicts between the activities of our indirect channels and our direct sales and marketing activities; and

• our global software vendors, systems integrators or value-added resellers may not give priority to the marketing of our products and services as compared to our competitors’ products.

The continued growth of our business may be adversely affected if we fail to form and maintain strategic relationships and business alliances.    Our development, marketing and distribution strategies rely increasingly on our ability to form strategic relationships with software and other technology companies. These business relationships often consist of cooperative marketing programs, joint customer seminars, lead referrals, and cooperation in product development. Many of these relationships are not contractual and depend on the continued voluntary cooperation of each party with us. Divergence in strategy or change in focus by, or competitive product offerings by, any of these companies may interfere with our ability to develop, market, sell, or support our products, which in turn could harm our business. Further, if these companies enter into strategic alliances with other companies or are acquired, they could reduce their support of our products. Our existing relationships may be jeopardized if we enter into alliances with competitors of our strategic partners. In addition, one or more of

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these companies may use the information they gain from their relationship with us to develop or market competing products.

Our increasing efforts to sell enterprise-wide software products and services could expose us to revenue variations and higher operating costs.    We increasingly focus our efforts on sales of enterprise-wide solutions, which consist of our entire Mercury Optimization Centers product suite and related professional services, and managed services, rather than on the sale of component products. As a result, each sale requires substantial time and effort from our sales and support staff as well as involvement by our professional services and managed services organizations and our systems integrator partners. Large individual sales, or even small delays in customer orders, can cause significant variation in our revenues and adversely affect our results of operations for a particular period. The timing of large orders is usually difficult to predict and, like many software and services companies, many of our customers typically complete transactions in the last month of a quarter.

If we are unable to manage rapid changes, our operating results could be adversely affected.    We have, in the past, experienced significant growth in revenue, employees and number of product and service offerings and we believe this growth may continue. This growth has placed a significant strain on our management and our financial, operational, marketing and sales systems. We are implementing and plan to implement in the future a variety of new or expanded business and financial systems, procedures, and controls, including the improvement of our sales and customer support systems. The implementation of these systems, procedures and controls may not be completed successfully, or may disrupt our operations or our data may not be transitioned properly. Any failure by us to properly manage these transitions could impair our ability to attract and service customers and could cause us to incur higher operating costs and experience delays in the execution of our business plan.

We have also in the past experienced reductions in revenue that required us to rapidly reduce costs. If we fail to reduce staffing levels when necessary, our costs would be excessive and our business and operating results could be adversely affected.

The success of our business depends on the efforts and abilities of our senior management and other key personnel.    We depend on the continued services and performance of our senior management and other key personnel. We do not have long-term employment agreements with any of our key personnel. The loss of any of our executive officers or other key employees could hurt our business. The loss of senior personnel can result in significant disruption to our ongoing operations, and new senior personnel must spend a significant amount of time learning our business and our systems in addition to performing their regular duties. Additionally, our inability to attract new senior executives and key personnel could significantly impact our business results. For example, Ken Klein, our Chief Operating Officer and member of our Board of Directors, left at the end of 2003 and we are in the process of hiring a new executive vice president of worldwide field operations who will assume these duties.

Our international sales and operations subject us to risks that can adversely affect our revenue and operating results.    Sales to customers located outside the U.S. have historically accounted for a significant percentage of our revenue and we anticipate that such sales will continue to be a significant percentage of our revenue. As a percentage of our total revenues, sales to customers outside the U.S. were 36%, 34%, and 35% for the years ended December 31, 2003, 2002, and 2001, respectively. We face risks associated with our international operations, including:

• changes in tax laws and regulatory requirements;

• difficulties in staffing and managing foreign operations;

• reduced protection for intellectual property rights in some countries;

• the need to localize products for sale in international markets;

• longer payment cycles to collect accounts receivable in some countries;

• seasonal reductions in business activity in other parts of the world in which we operate;

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• changes in foreign currency exchange rates;

• geographical turmoil, including terrorism and wars;

• country or regional political and economic instability; and

• economic downturns in international markets.

Any of these risks could harm our international operations and reduce our international sales. For example, some countries in Europe, the Middle East and Africa already have laws and regulations related to technologies used on the Internet that are more strict than those currently in force in the U.S. Any or all of these factors could cause our business and operating results to be harmed.

Because our research and development operations are primarily located in Israel, we may be affected by volatile political, economic, and military conditions in that country and by restrictions imposed by that country on the transfer of technology.    Our operations depend on the availability of highly skilled scientific and technical personnel in Israel. Our business also depends on trading relationships between Israel and other countries. In addition to the risks associated with international sales and operations generally, our operations could be adversely affected if major hostilities involving Israel should occur or if trade between Israel and its current trading partners were interrupted or curtailed.

These risks are compounded due to the restrictions on our ability to manufacture or transfer outside of Israel any technology developed under research and development grants from the government of Israel without the prior written consent of the government of Israel. If we are unable to obtain the consent of the government of Israel, we may not be able to take advantage of strategic manufacturing and other opportunities outside of Israel.

We are subject to the risk of increased taxes if tax rate incentives in Israel are altered or if there are other changes in tax laws or rulings.    Historically, our operations resulted in a significant amount of income in Israel where tax rate incentives have been extended to encourage foreign investment. Our taxes could increase if these tax rate incentives are not renewed upon expiration or tax rates applicable to us are increased. Tax authorities could challenge the manner in which profits are allocated between our subsidiaries and us, and we may not prevail in any such challenge. If the profits recognized by our subsidiaries in jurisdictions where taxes are lower became subject to income taxes in other jurisdictions, our worldwide effective tax rate would increase. In addition, to the extent that we are unable to continue to reinvest a substantial portion of our profits in our Israeli operations, we may be subject to additional tax rate increases in the future.

Other factors that could increase our effective tax rate include the effect of changing economic conditions, business opportunities, and changes in tax laws and rulings. We have in the past and may continue in the future to retire amounts outstanding under our 2000 Notes. To the extent that these repurchases are completed below the par value of the 2000 Notes, we may generate a taxable gain from these repurchases. These gains may result in an increase in our effective tax rate. Merger and acquisition activities, if any, could result in nondeductible expenses, which may increase our effective tax rate.

Our financial results may be negatively impacted by foreign currency fluctuations.    Our foreign operations are generally transacted through our international sales subsidiaries in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan. The Americas includes Brazil, Canada, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. As a result, these sales and related expenses are denominated in currencies other than the U.S. dollar. Because our financial results are reported in U.S. dollars, our results of operations may be adversely impacted by fluctuations in the rates of exchange between the U.S. dollar and other currencies, including:

• a decrease in the value of currencies in certain of the Americas, EMEA, APAC or Japan relative to the U.S. dollar, which would decrease our reported U.S. dollar revenue, as we generate revenue in these local currencies and report the related revenue in U.S. dollars; and

39

• an increase in the value of currencies in certain of the Americas, EMEA, APAC or Japan, or Israel relative to the U.S. dollar, which would increase our sales and marketing costs in these countries and would increase research and development costs in Israel.

We attempt to limit foreign exchange exposure through operational strategies and by using forward contracts to offset the effects of exchange rate changes on intercompany trade balances. This requires us to estimate when revenue will be earned and cash will be collected. We may not be successful in making these estimates. If these estimates are overstated or understated during periods of currency volatility, we could experience material currency gains or losses on forward contracts and our financial position and results of operations may be significantly impacted.

Acquisitions may be difficult to integrate, disrupt our business, dilute stockholder value, or divert the attention of our management and may result in financial results that are different than expected.    In August 2003, we acquired Kintana. In addition, in May 2003, we completed our acquisition of Performant and in May 2001, we acquired Freshwater Software. In the event of any future acquisitions, we could:

• issue stock that would dilute the ownership of our then-existing stockholders;

• incur debt;

• assume liabilities;

• incur charges for the impairment of the value of acquired assets; or

• incur amortization expense related to intangible assets.

If we fail to achieve the financial and strategic benefits of past and future acquisitions, our operating results will suffer. Acquisitions involve numerous other risks, including:

• difficulties in integrating or coordinating the different research and development, sales programs, facilities, operations, technologies or products;

• failure to achieve targeted synergies;

• unanticipated costs and liabilities;

• diversion of management’s attention from our core business;

• adverse effects on our existing business relationships with suppliers and customers or those of the acquired organization;

• difficulties in entering markets in which we have no or limited prior experience; and

• potential loss of key employees, particularly those of the acquired organizations.

In addition, for purchase acquisitions completed to date, the development of these technologies remains a significant risk due to the remaining efforts to achieve technical feasibility, changing customer markets and uncertainty of new product standards. Efforts to develop these technologies into commercially viable products consist of planning, designing, experimenting, and testing activities necessary to determine that the technologies can meet market expectations, including functionality and technical requirements. Failure to bring these products to market in a timely manner could result in a loss of market share or a lost opportunity to capitalize on emerging markets, and could have a material adverse impact on our business and operating results.

In the normal course of business, we frequently engage in discussions with parties relating to possible acquisitions. As a result of such transactions, our financial results may differ from the investment community’s expectations in a given quarter. Further, if market conditions or other factors lead us to change our strategic direction, we may not realize the expected value from such transactions. If we do not realize the expected benefits or synergies of such transactions, our consolidated financial position, results of operations, cash flows and stock price could be negatively impacted.

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If we are required to account for stock options under our employee stock plans as a compensation expense, our net income and our earnings per share would be significantly reduced.    There has been an increasing public debate about the proper accounting treatment for equity-based compensation, such as employee stock options and employee stock purchase plan shares and whether they should be treated as a compensation expense and, if so, how to properly value such charges. If we elected or were required to record an expense for our employee stock plans using the fair value method, we would be required to recognize significant stock-based compensation charges. For stock option grants that have an exercise price at fair market value we calculate compensation expense using a fair value method and disclose the pro forma impact on net income (loss) and net income (loss) per share, see Note 1 to our consolidated financial statements. Although we are not currently required to record any compensation expense using the fair value model in connection with option grants that have an exercise price at or above fair market value and for shares issued under our employee stock purchase plan, it is possible that future laws and regulations will require us to treat all stock-based compensation as a compensation expense in our consolidated statement of operations using the fair value method.

Investments may become impaired and require us to take a charge against earnings.    As of December 31, 2003, we had investments in non-consolidated companies of $13.9 million. Our investments in early stage private companies and a private equity fund were $13.5 million and the fair value of a warrant to purchase common stock of a private company was $0.4 million. In addition, we have committed to invest in the private equity fund for a total of $15.0 million. As of December 31, 2003, we have made capital contributions to this fund totaling $6.4 million. We may be required to incur charges for the impairment of value of our investments. For example, for the year ended December 31, 2003, we recorded losses of $2.4 million, $0.6 million and $0.5 million, respectively, on three of our investments in non-consolidated companies, and a loss of $0.4 million on our investment in a private equity fund. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million and $0.4 million on three of our investments in non-consolidated companies, respectively. In calculating the loss to be recorded, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to outside third party investors. For the year ended December 31, 2001, we did not record any losses on our investments in early stage private companies and the private equity fund. We are closely monitoring the financial health of the private companies in which we hold minority equity investments. We may continue to make investments in other companies. If we determine in accordance with our standard accounting policies that an impairment has occurred, then additional losses would be recorded.

In addition, we hold a warrant to purchase common stock of a private company. The warrant is treated as a derivative instrument due to a net settlement provision. The warrant is recorded at its fair value on each reporting date. We calculate the fair value of the warrant using the Black-Scholes option-pricing model. Estimating the fair value of the warrant requires management judgment and may have an impact on our financial positions and results of operations.

If we fail to adequately protect our proprietary rights and intellectual property, we may lose a valuable asset, experience reduced revenue, and incur costly litigation to protect our rights.    Our success depends in large part of our proprietary technology. We rely on a combination of patents, copyrights, trademarks, service marks, trade secret, and contractual restrictions (including confidentiality provisions and licensing arrangements) to establish and protect our proprietary rights in our products and services. We will not be able to protect our intellectual property if we are unable to enforce our rights or if we do not detect unauthorized use of our intellectual property. Despite our precautions, it may be possible for unauthorized third parties to copy our products and services and use information that we regard as proprietary to create products and services that compete with ours. Some license provisions protecting against unauthorized use, copying, transfers and disclosures of our licensed programs may be unenforceable under the laws of certain jurisdictions and foreign countries. Further, the laws of some countries do not protect proprietary rights to the same extent as the laws of the U.S. To the extent that we increase our international activities, our exposure to unauthorized copying and use of our products and proprietary information will increase. If we fail to successfully enforce our intellectual property rights, our competitive position could suffer, which could harm our operating results. In addition, we are not significantly dependent on any of our patents as we do not generally license our patents to other companies and do not receive any revenue as a direct result of our patents.

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In many cases, we enter into confidentiality or license agreements with our employees and consultants and with the customers and corporations with whom we have strategic relationships and business alliances. No assurance can be given that these agreements will be effective in controlling access to and distribution of our products and proprietary information. Further, these agreements do not prevent our competitors from independently developing technologies that are substantially equivalent or superior to our products.

Litigation may be necessary in the future to enforce our intellectual property rights and to protect our trade secrets. Litigation, whether successful or unsuccessful, could result in substantial costs and diversions of our management resources, which could result in lower revenue, higher operating costs, and adversely affect our operating results.

Third parties could assert that our products and services infringe their intellectual property rights, which could expose us to litigation that, with or without merit, could be costly to defend.    We may from time to time be subject to claims of infringement of other parties’ proprietary rights. We could incur substantial costs in defending ourselves and our customers against these claims. Parties making these claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products in the U.S. and abroad and could result in an award of substantial damages against us. In the event of a claim of infringement, we may be required to obtain licenses from third parties, develop alternative technology, or to alter our products or processes or cease activities that infringe the intellectual property rights of third parties. If we are required to obtain licenses, we cannot be sure that we will be able to do so at a commercially reasonable cost, or at all. Defense of any lawsuit or failure to obtain required licenses could delay shipment of our products and increase our costs. In addition, any such lawsuit could result in our incurring significant costs or the diversion of the attention of our management.

If we fail to obtain or maintain early access to third-party software, our future product development may suffer.    Software developers have, in the past, provided us with early access to pre-generally available versions of their software in order to have input into the functionality and to ensure that we can adapt our software to exploit new functionality in these systems. Some companies, however, may adopt more restrictive policies in the future or impose unfavorable terms and conditions for such access. These restrictions may result in higher research and development costs for us in connection with the enhancement and modification of our existing products and the development of new products or may prevent us from being able to develop products which will work with such new systems, which could harm our business.

We have adopted anti-takeover defenses that could delay or prevent an acquisition of our company, including an acquisition that would be beneficial to our stockholders.    We have adopted a Preferred Shares Rights Agreement (which we refer to as our Shareholder Rights Plan) on July 5, 1996, as amended. In connection with the Shareholder Rights Plan, our Board of Directors declared and paid a dividend of one preferred share purchase right for each share of our common stock outstanding on July 15, 1996. In addition, each share of common stock issued after July 15, 1996 was issued, or will be issued, with an accompanying preferred stock purchase right. Because the rights may substantially dilute the stock ownership of a person or group attempting to take us over without the approval of our Board of Directors, the Shareholder Rights Plan could make it more difficult for a third party to acquire us (or a significant percentage of our outstanding capital stock) without first negotiating with our Board of Directors regarding such acquisition.

Our Board of Directors also has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of common stock will be subject to, and may be adversely affected by, the rights of the holders of any preferred stock that may be issued in the future. The issuance of preferred stock, while providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present plans to issue shares of preferred stock.

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In addition, we are subject to the provisions of Section 203 of the Delaware General Corporation Law, which will prohibit us from engaging in a business combination with an interested stockholder for a period of three years after the date that the person became an interested stockholder unless, subject to certain exceptions, the business combination or the transaction in which the person became an interested stockholder is approved in a prescribed manner.

Furthermore, certain provisions of our Amended and Restated Certificate of Incorporation may have the effect of delaying or preventing changes in our control or management, which could adversely affect the market price of our common stock.

Leverage and debt service obligations for $800.0 million in outstanding Notes may adversely affect our cash flow.    On April 29, 2003, we issued our 2003 Notes, with a principal amount of $500.0 million, in a private placement, and in July 2000, we completed the offering of the 2000 Notes with a principal amount of $500.0 million. From December 2001 through December 31, 2003, we retired $200.0 million face value of our 2000 Notes. We continue to carry a substantial amount of outstanding indebtedness, primarily the 2000 Notes and the 2003 Notes. There is the possibility that we may be unable to generate cash sufficient to pay the principal of, interest on, and other amounts in respect of our indebtedness when due. Our leverage could have significant negative consequences, including:

• increasing our vulnerability to general adverse economic and industry conditions;

• requiring the dedication of a substantial portion of our expected cash flow from operations to service our indebtedness, thereby reducing the amount of our expected cash flow available for other purposes, including capital expenditures and acquisitions; and

• limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we compete.

In November 2002, we entered into an interest rate swap with Goldman Sachs Capital Markets, L.P. (GSCM) with respect to $300.0 million of our 2000 Notes. This interest rate swap could expose us to greater interest expense for our 2000 Notes.

In addition, the 2003 Notes would be included in our diluted net income per share calculation if our common stock price reaches a specified threshold or if specified corporate transactions have occurred and if we elect to settle in stock instead of cash. In this case, 9,673,050 shares would be included in both the basic and diluted weighted average common shares and equivalents.

The price of our common stock may fluctuate significantly, which may result in losses for investors and possible lawsuits.    The market price for our common stock has been and may continue to be volatile. For example, during the 52-week period ended February 27, 2004, the closing sale prices of our common stock as reported on the NASDAQ National Market ranged from a high of $54.00 to a low of $29.68. We expect our stock price to be subject to fluctuations as a result of a variety of factors, including factors beyond our control. These factors include:

• actual or anticipated variations in our quarterly operating results;

• announcements of technological innovations or new products or services by us or our competitors;

• announcements relating to strategic relationships, acquisitions or investments;

• changes in financial estimates or other statements by securities analysts;

• changes in general economic conditions;

• terrorist attacks, and the effects of war;

• conditions or trends affecting the software industry and the Internet;

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• changes in the rating of our notes or other securities; and

• changes in the economic performance and/or market valuations of other software and high-technology companies.

Because of this volatility, we may fail to meet the expectations of our stockholders or of securities analysts at some time in the future, and the trading prices of our securities could decline as a result. In addition, the stock market has experienced significant price and volume fluctuations that have particularly affected the trading prices of equity securities of many high-technology companies. These fluctuations have often been unrelated or disproportionate to the operating performance of these companies. Any negative change in the public’s perception of software or internet software companies could depress our stock price regardless of our operating results. Because the 2000 and 2003 Notes are convertible into shares of our common stock, volatility or depressed prices for our common stock could have a similar effect on the trading price of these Notes. Holders who receive common stock upon conversion also will be subject to the risk of volatility and depressed prices of our common stock. In addition, the existence of these Notes may encourage short selling in our common stock by market participants because the conversion of these Notes could depress the price of our common stock.

Item 7a.    Quantitative and Qualitative Disclosures about Market Risk

Our exposure to market rate risk includes risk of change in interest rate, foreign exchange rate fluctuations, and loss in equity investments.

Interest Rate Risk:

We mitigate market risk associated with our investments by placing our investments with high quality issuers and, by policy, limit the amount of credit exposure to any one issuer or issue. In addition, we have classified all of our investments as “held to maturity.” At December 31, 2003, $549.3 million, or 45% of our cash, cash equivalents, and investment portfolio have a maturity of less than 90 days, and an additional $157.1 million, or 13%, carried a maturity of less than one year. All investments mature, by policy, in less than three years. Information about our investment portfolio is presented in the table below, which states notional amounts and related weighted-average interest rates by year of maturity (in thousands):

	December 31,
	2004			2005			2006			Total			Fair Value
Investments maturing within 30 days at December 31, 2003
Fixed rate	$	329,950		$	—		$	—		$	329,950		$	329,980
Weighted average rate		1.25	%		—			—			1.25	%		—
Investments maturing 30 days after December 31, 2003
Fixed rate	$	302,183		$	130,571		$	396,777		$	829,531		$	832,136
Weighted average rate		2.14	%		2.25	%		2.27	%		2.22	%		—
Total investments	$	632,133		$	130,571		$	396,777		$	1,159,481		$	1,162,116
Weighted average rate		1.69	%		2.25	%		2.27	%		1.95	%		—

Our long-term investments include $463.1 million of government agency instruments, which have callable provisions and accordingly may be redeemed by the agencies should interest rates fall below the coupon rate of the investments.

The fair value of our 2000 Notes fluctuates based upon changes in the price of our common stock, changes in interest rates, and changes in our creditworthiness. The fair market value of our 2000 Notes at December 31, 2003 was $297.4 million while the face value and book value was $300.0 million and $311.2 million, respectively. To mitigate the risk of fluctuation in the fair value of our 2000 Notes, we entered into interest rate

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swap arrangements. The fair value of our 2003 Notes fluctuates based upon changes in the price of our common stock and changes in our creditworthiness. The fair market value of the 2003 Notes at December 31, 2003 was $574.5 million while the face value and the book value was $500.0 million. See Note 7 to the consolidated financial statements for transactions regarding our 2000 and 2003 Notes.

In November 2002, we merged our January and February 2002 interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) into a single interest rate swap with GSCM to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap, with a maturing date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) of $300.0 million of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on our 2000 Notes to a variable interest rate based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value attributable to changes in the LIBOR throughout the life of our 2000 Notes. The interest rate swap creates a market exposure to changes in the LIBOR. If the LIBOR increases or decreases by 1%, our interest expense would increase or decrease by $750,000 quarterly on a pretax basis. According to the terms of the swap, we are required to provide initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash on our consolidated balance sheets. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted our 2000 Notes.

We are exposed to credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligations under the swap is guaranteed by the Goldman Sachs Group L.P.

Also, see Notes 7 and 12 to the consolidated financial statements for additional information regarding our 2000 Notes and the interest rate swap activities.

Foreign exchange rate risk

A portion of our business is conducted in currencies other than the U.S. dollar. Our operating expenses in each of these countries are in the local currencies, which mitigates a significant portion of the exposure related to local currency revenue. We enter into foreign exchange forward contracts to minimize the short-term impact of foreign currency fluctuations on foreign currency denominated deferred revenues and receivables due from certain subsidiaries and foreign branches in the Americas, EMEA, APAC, and Japan. We had outstanding forward contracts with notional amounts totaling $31.5 million and $17.5 million at December 31, 2003 and 2002, respectively. The forward contracts in effect at December 31, 2003 mature at various dates through December 2004 and were hedges of certain foreign currency transaction exposures in the British Pound, Canadian Dollar, Danish Kroner, Euro, Japanese Yen, Norwegian Kroner, Singapore Dollar, South African Rand, and Swiss Franc.

We also utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Australian Dollar, Canadian Dollar, British Pound, Euro, Israeli Shekel, and Swedish Kroner. We had outstanding forward contracts with notional amounts totaling $42.6 million at December 31, 2003. There were no forward contracts outstanding at December 31, 2002.

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Gains or losses on forward contracts are recognized as “Other income (expense), net” in our consolidated statement of operations in the same period as gains or losses on the underlying transactions. Net gains or losses on forward contracts and the underlying transactions did not have any material impact to our financial position. In addition, the effect of an immediate 10% change in exchange rates would not have a material impact on our operating results or cash flows.

Investment risk

From time to time, we make investments in early stage private companies and private equity funds for business and strategic purposes. At December 31, 2003, our investments in private companies and a private equity fund were $13.5 million. In addition, we made capital contributions to the private equity fund totaling $6.4 million and we have committed to pay up to $8.6 million in the future. If the companies in which we have made investments do not complete initial public offerings or are not acquired by publicly traded companies, we may not be able to sell these investments. In addition, even if we are able to sell these investments, we cannot assure that we will be able to sell them at a gain or even recover our investment. The potential decline in the NASDAQ National Market and the market prices of publicly traded technology companies will adversely affect our ability to realize gains or a return of our capital on many of these investments. For the year ended December 31, 2003, we recorded losses of $2.5 million, $0.6 million, and $0.4 million on three of our investments in early stage private companies and a loss of $0.4 million on our investment in a private equity fund. For the year ended December 31, 2002, we recorded losses of $3.4 million, $1.5 million, and $0.4 million on three of our investments in early stage private companies. In calculating the loss to be recorded, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to outside third party investors.

In addition, we hold a warrant to purchase common stock of a private company. The warrant is treated as a derivative instrument due to a net settlement provision. Since the warrant is marked to market at each reporting date, any fluctuations in the fair value of the warrant may have an impact on our financial positions and results of operations. As of December 31, 2003, the fair value of the warrant was $0.4 million.

Item 8.    Financial Statements and Supplementary Data

Financial statements required pursuant to this Item are presented beginning on page F-1 of this report.

Item 9.    Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A.    Controls and Procedures

(a) Disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our “disclosure controls and procedures” (as defined in the Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this Annual Report on Form 10-K, have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were adequate and designed to ensure that material information related to us and our consolidated subsidiaries would be made known to them by others within these entities.

(b) Changes in internal controls over financial reporting. There were no changes in our internal controls over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rule 13a-15 or 15d-15 that occurred during the fourth fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART III

Certain information required by Part III is omitted from this Annual Report on Form 10-K because we will file a definitive proxy statement within 120 days after the end of our fiscal year pursuant to Regulation 14A for our annual meeting of stockholders, currently scheduled for May 19, 2004, and the information included in the proxy statement is incorporated herein by reference.

Item 10.    Directors and Executive Officers of the Registrant

Our executive officers as of February 29, 2004 are as follows:

Name	Age	Position
Amnon Landan	45	President, Chief Executive Officer and Chairman of the Board of Directors
Douglas P. Smith	52	Executive Vice President and Chief Financial Officer
Bryan J. LeBlanc	37	Vice President of Finance and Operations
David Murphy	41	Vice President of Corporate Development and Business Transformation
Yuval Scarlat	40	Vice President of Products
Susan J. Skaer	40	Vice President, General Counsel and Secretary

Mr. Amnon Landan has served as our President and Chief Executive Officer since February 1997, has served as Chairman of the Board of Directors since July 1999, and has been a director since February 1996. From October 1995 to January 1997, he served as President, and from March 1995 to September 1995, he served as President of North American Operations. He served as Chief Operating Officer from August 1993 until March 1995. From December 1992 to August 1993, he served as our Vice President of Operations and from June 1991 to December 1992, he served as Vice President of Research and Development. From November 1989 to June 1991, he served with us in various technical positions.

Mr. Douglas Smith has served as our Executive Vice President and Chief Financial Officer since November 2001. He served as our Executive Vice President of Corporate Development from May 2000 until November 2001. From September 1996 to May 2000, he served in various positions with Hambrecht & Quist, most recently as Managing Director and co-head of the Internet Group. From September 1994 to September 1996, he was the Chief Financial Officer and Executive Vice President of Strategy for ComputerVision Corporation.

Mr. Bryan LeBlanc has served as our Vice President of Finance and Operations since May 2002. Prior to joining the company, he served as Executive Vice President and Chief Financial Officer for inSilicon Inc., a software company developing intellectual property for semiconductor communication, from March 2001 to May 2002. From March 2000 to March 2001, Mr. LeBlanc was Vice President of Finance and Chief Financial Officer of Fogdog, Inc., an online retailer of sports equipment, and from November 1999 to March 2000, he was the Director of Finance of Fogdog. From April 1997 to November 1999, Mr. LeBlanc was the Director of Corporate Finance for Documentum, Inc., an enterprise content management software development company. Prior to that, between 1988 and 1997, he held various financial management positions with Cadence Design Systems, Inc., an electronic design automation software company.

Mr. David Murphy has served as our Vice President of Corporate Development and Business Transformation since January 2003. From May 2001 to December 2002, he was President and Chief Executive Officer of Asera, a provider of business process enterprise solutions. Before joining Asera, from March 1998 to May 2001 Mr. Murphy was President and General Manager of Tivoli Systems at IBM, a division of IBM, and leading provider of systems management solutions. Prior to joining Tivoli, he was head of the private equity investments group at Perot Systems and a partner at McKinsey & Company.

Mr. Yuval Scarlat has served as our Vice President of Products since January of 2004. From January 2002 to January 2004, he was Vice President and General Manager of Testing & Deployment. From January 2000

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to January 2002, he served as our President of Managed Services. From July 1996 to December 2000, he served as our Vice President of Technical Services. From 1990 to July 1996, he served with us in various technical and marketing positions.

Ms. Susan Skaer has served as our Vice President, General Counsel and Secretary since November 2000. From October 1996 to November 2000, Ms. Skaer was a partner with the law firm GCA Law Partners LLP (formerly General Counsel Associates LLP). From September 1990 to October 1996, Ms. Skaer was an associate with the law firm Wilson Sonsini Goodrich & Rosati.

The information concerning our directors required by this Item is incorporated by reference to our proxy statement under the heading “Election of Directors – Nominees” in our proxy statement.

The information concerning our audit committee financial expert required by this Item is incorporated by reference to our proxy statement under the “Audit Committee” under the heading “Board Structure and Compensation.”

The information concerning compliance with Section 16(a) of the Exchange Act required by this Item is incorporated by reference to our proxy statement under the heading “Section 16(a) Beneficial Ownership Reporting Compliance.”

Our Code of Business Conduct and Ethics (including code of ethics provisions that apply to our principal executive officer, principal financial officer, controller and senior financial officers) is available on our website at www.mercuryinteractive.com/company/ir/docs under “Corporate Governance.” We will post amendments to or waivers from a provision of the Code of Business Conduct and Ethics on our website at www.mercuryinteractive.com/company/ir/docs under “Corporate Governance.”

Item 11.    Executive Compensation

The information required by this Item is incorporated by reference to our proxy statement under the heading “Executive Compensation.”

Item 12.    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information about security ownership of certain beneficial owners and management required by this Item is incorporated by reference to our proxy statement under the heading “Security Ownership of Certain Beneficial Owners and Management.”

The information regarding securities authorized for issuance under equity compensation plans required by this item is incorporated by reference to our proxy statement under the heading “Equity Compensation Plan Information.”

Item 13.    Certain Relationships and Related Transactions

The information required by this Item is incorporated by reference to our proxy statement under the heading “Certain Transactions.”

Item 14.    Principal Accountant Fees and Services

The information required by this Item is incorporated by reference to our proxy statement under the heading “Principal Auditor Fees and Services.”

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PART IV

Item 15.    Exhibits, Financial Statement Schedules and Reports on Form 8-K

(a)  The following documents are filed as a part of this report:

1.    Financial Statements.

The following financial statements of Mercury Interactive Corporation are filed as a part of this report:

	Page
Report of Independent Auditors	F-1
Consolidated Balance Sheets at December 31, 2003 and 2002	F-2
Consolidated Statements of Operations for the years ended December 31, 2003, 2002, and 2001	F-3
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2003, 2002, and 2001	F-4
Consolidated Statements of Cash Flows for the years ended December 31, 2003, 2002, and 2001	F-5
Notes to Consolidated Financial Statements	F-6

2.    Schedules

Financial statement schedules not listed above have been omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.

3.    Exhibits

Exhibit Number	Description
3.1(1)	Certificate of Incorporation of Mercury Interactive, as amended and restated to date.
3.2(12)	Certificate of Amendment of the Restated Certificate of Incorporation.
3.3	Amended and Restated Bylaws of Mercury Interactive.
10.1(4),(2)	Amended and Restated 1989 Stock Option Plan and forms of Incentive Stock Option Agreement and Nonstatutory Stock Option Agreement.
10.2(1)	Form of Directors’ and Officers’ Indemnification Agreement.
10.3(14),(2)	Form of 1998 Employee Stock Purchase Plan and form of Agreements.
10.4(1)	401(k) Plan.
10.5(5),(2)	1994 Directors’ Stock Option Plan and form of Agreements.
10.6(6),(2)	Form of Change of Control Agreements entered into by Mercury Interactive with the Chairman, the Chief Executive Officer, the Executive Vice President and the Chief Financial Officer, Chief Operating Officer and the President of European Operations and Vice President and General Counsel.
10.7(7),(2)	Amended and Restated 2000 Supplemental Stock Option Plan.
10.8(7),(2)	Amended and Restated 1999 Stock Option Plan.
10.9(9)	Preferred Share Purchase Rights Agreement.
10.10(10)	Amendment to Rights Agreement dated March 31, 1999.
10.11(11)	Amendment No. Two to Rights Agreement, dated May 19, 2000.
10.12(12)	Purchase and Sale Agreement by and between WHSUM Real Estate Limited Partnership and Mercury Interactive.
10.13(8)	Form of Note for Mercury Interactive 4.75% Convertible Subordinated Notes due July 1, 2007.

49

Exhibit Number	Description
10.14(8)	Indenture between Mercury Interactive, as Issuer and Chase Manhattan Bank and Trust Company, National Association, as Trustee dated July 3, 2000 related to Mercury Interactive 4.75% Convertible Subordinated Notes due July 1, 2007.
10.15(8)	Registration Rights Agreement among Mercury Interactive and Goldman, Sachs & Chase Securities Inc. and Deutsche Banc Securities Inc. dated June 27, 2000 related to the Mercury Interactive 4.75% Convertible Subordinated Notes due July 1, 2007.
10.16(12)(2)	Amended and Restated Employment Agreement by and between Mercury Interactive and Douglas P. Smith effective as of August 28, 2000.
10.17(13)	Agreement and Plan of Merger among Freshwater Software, Inc., Mercury Interactive Corporation and Aqua Merger Company dated as of May 1, 2001.
10.18(15)	Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated January 17, 2002 (as revised on January 31, 2002), and Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated February 26, 2002.
10.19	Lease Agreement by and between 369 Whisman Associates, L.P. and Mercury Interactive, dated as of December 15, 2003.
10.20	Letter Agreement by and between Mercury Interactive and Kenneth Klein, effective as of December 30, 2003.
10.21(16),(2)	Conduct Ltd. 1998 Share Option Plan
10.22(17),(2)	Freshwater Software, Inc. 1997 Stock Plan
10.23(18),(2)	Performant, Inc. 2000 Stock Option/Restricted Stock Plan
10.24(19),(2)	Kintana, Inc. 1997 Equity Incentive Plan
10.25(19),(2)	Chain Link Technologies Limited Company Share Option Scheme
10.26(20)	Indenture, dated as of April 29, 2003, by and between Mercury Interactive Corporation and U.S. Bank National Association related to Zero Coupon Senior Convertible Notes due 2008.
10.27(20)	Form of Note for Mercury Interactive’s Zero Coupon Senior Convertible Notes due 2008.
10.28(20)	Registration Rights Agreement, dated as of April 23, 2003, by and between Mercury Interactive Corporation and UBS Warburg LLC related to Zero Coupon Senior Convertible Notes due 2008.
10.29(20)	Amendment No. 3 Rights Agreement dated April 23, 2003.
10.30(20)	Confirmation regarding Swap Transaction from Goldman Sachs Capital Markets, L.P. dated November 5, 2002.
14.1(21)	Code of Business Conduct and Ethics
21.1	Subsidiaries of Mercury Interactive.
23.1	Consent of Independent Auditors
24.1	Power of Attorney (see page 53).
31.1	Certification of the Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of the Chief Financial Officer pursuant to Securities Exchange Act Rules 13a-14 and 15d-14 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

50

  (1) Exhibits 3.1, 10.2, and 10.4 are incorporated by reference to Exhibits 3.3, 10.2, and 10.12, respectively, filed in response to Item 16(a), “Exhibits,” of Mercury Interactive Registration Statement on Form S-1, as amended, No. 33-68554, which was declared effective on October 29, 1993.

  (2) Designates management contract or compensatory plan arrangements required to be filed as an exhibit of this Annual Report on Form 10-K.

  (3) Reserved.

  (4) Exhibit 10.1 is incorporated by reference to Exhibit 4.1 filed with the Registration Statement on Form S-8, No. 333-62125, filed with the Securities and Exchange Commission on August 24, 1998.

  (5) Exhibit 10.5 is incorporated by reference to Exhibit 10.1 filed with the Form 10-Q for the quarter ended September 30, 1994.

  (6) Exhibit 10.6 is incorporated by reference to Exhibit 10.26 filed with the Form 10-K for the year ended December 31, 1998.

  (7) Exhibits 10.7 and 10.8 are incorporated by reference to Exhibits 4.2 and 4.1 filed with the Registration Statement on Form S-8, No. 333-56316, filed with the Securities and Exchange Commission on February 28, 2001.

  (8) Exhibits 10.13, 10.14 and 10.15 are incorporated by reference to Exhibits 4.1, 4.2 and 4.3, respectively, filed with the Form 10-Q for the quarter ended June 30, 2000.

  (9) Exhibit 10.9 is incorporated by reference to Exhibit 1 to Form 8-A, filed with the Securities and Exchange Commission on July 9, 1996.

(10) Exhibit 10.10 is incorporated by reference to Exhibit 1 to Form 8-A, Amendment No. 1, filed with the Securities and Exchange Commission on April 2, 1999.

(11) Exhibit 10.11 is incorporated by reference to Exhibit 1 to Form 8-A, Amendment No. 2, filed with the Securities and Exchange Commission on May 22, 2000.

(12) Exhibits 3.2, 10.12, and 10.16 are incorporated by reference to Exhibit 3.2, 10.12 and 10.16, respectively, filed with the Form 10-K for the year ended December 31, 2000.

(13) Exhibit 10.17 is incorporated by reference to Exhibit 10.1 filed with the Form 10-Q for the quarter ended June 30, 2001.

(14) Exhibit 10.3 is incorporated by reference to Exhibit 4.1 filed with the Registration Statement on Form S-8, No. 333-98031, filed with the Securities and Exchange Commission on August 13, 2002.

(15) Exhibit 10.18 is incorporated by reference to Exhibit 10.18 filed with the Form 10-K for the year ended December 31, 2001.

(16) Exhibit 10.21 is incorporated by reference to Exhibit 4.1 filed with the Registration Statement on Form S-8, No. 333-94837, filed with the Securities and Exchange Commission on January 18, 2000.

(17) Exhibit 10.22 is incorporated by reference to Exhibit 4.1 filed with the Registration Statement on Form S-8, No. 333-61786, filed with the Securities and Exchange Commission on May 29, 2001.

(18) Exhibit 10.23 is incorporated by reference to Exhibit 4.1 filed with the Registration Statement on Form S-8, No. 333-106646, filed with the Securities and Exchange Commission on June 30, 2003.

(19) Exhibits 10.24 and 10.25 are incorporated by reference to Exhibits 4.1 and 4.2, respectively, filed with the Registration Statement on Form S-8, No. 333-108266, filed with the Securities and Exchange Commission on August 27, 2003.

(20) Exhibits 10.26 and 10.27 are each incorporated by reference to Exhibit 4.1 filed with the Form 10-Q for the quarter ended March 31, 2003 and Exhibits 10.28, 10.29 and 10.30 are incorporated by reference to Exhibits 4.2, 4.3 and 10.1, respectively, filed with the Form 10-Q for the quarter ended March 31, 2003.

(21) See Item 10, Directors and Executive Officers of the Registrant of this Annual Report on Form 10-K.

51

(b) Reports on Form 8-K

We filed or furnished the following Current Report on Form 8-K and Form 8-K/A during the quarter ended December 31, 2003:

• Current Report on Form 8-K dated October 22, 2003, announcing earnings for the quarter ended September 30, 2003 and attached press release related thereto.

• Current Report on Form 8-K/A dated October 31, 2003, an amendment to a previously filed Form 8-K dated August 28, 2003, reporting (i) audited consolidated financial statements of Kintana for the year ended December 31, 2002 and unaudited condensed consolidated financial statements of Kintana as of June 30, 2003 and for the six months ended June 30, 2002 and 2003, which are required by paragraph (a) of Item 7 of Form 8-K with respect to the acquisition of Kintana on August 15, 2003 and (ii) furnishing pro forma financial information required by paragraph (b) of Item 7 of Form 8-K with respect to the acquisition of Kintana.

52

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant, Mercury Interactive Corporation, a corporation organized and existing under the laws of the State of Delaware, has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

Dated: March 5, 2004

MERCURY INTERACTIVE CORPORATION (Registrant)
By:	/s/    DOUGLAS P. SMITH
	Douglas P. Smith, Executive Vice President and Chief Financial Officer

By:	/S/    BRYAN J. LEBLANC
	Bryan J. LeBlanc Vice President, Finance and Operations Principal Accounting Officer

KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints jointly and severally, Amnon Landan, Susan J. Skaer and/or Douglas P. Smith and each one of them, his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes, may do or cause to be done by virtue hereof.

Signature	Title	Date
/S/    AMNON LANDAN         Amnon Landan	President and Chief Executive Officer     (Principal Executive Officer) and     Chairman of the Board of Directors	March 5, 2004
/S/    DOUGLAS P. SMITH         Douglas P. Smith	Executive Vice President and     Chief Finance Officer (Principal     Financial Officer)	March 5, 2004
/S/    BRYAN J. LEBLANC         Bryan J. LeBlanc	Vice President, Finance and Operations     (Principal Accounting Officer)	March 5, 2004
/S/    IGAL KOHAVI         Igal Kohavi	Director	March 5, 2004
/S/    YAIR SHAMIR         Yair Shamir	Director	March 5, 2004
/S/    GIORA YARON         Giora Yaron	Director	March 5, 2004
/S/    CLYDE OSTLER         Clyde Ostler	Director	March 5, 2004
/S/    ANTHONY ZINGALE         Anthony Zingale	Director	March 5, 2004

53

REPORT OF INDEPENDENT AUDITORS

To the Board of Directors and Stockholders of

Mercury Interactive Corporation

In our opinion, the consolidated financial statements listed in the index appearing under Item 15(a)(1) present fairly, in all material respects, the financial position of Mercury Interactive Corporation and its subsidiaries (the Company) at December 31, 2003 and 2002, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

As discussed in Note 6 to the consolidated financial statements, effective January 1, 2002, the Company changed its method of accounting for goodwill in accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.

/s/ PRICEWATERHOUSECOOPERS LLP

San Jose, California

January 19, 2004, except for Note 17,

    which is as of February 8, 2004

F-1

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

	December 31,
	2003			2002
ASSETS
Current assets:
Cash and cash equivalents	$	549,278		$	349,123
Short-term investments		157,082			178,123
Trade accounts receivable, net of sales reserves of $6,117 and $7,431, respectively		142,908			93,095
Deferred tax assets		—			9,407
Prepaid expenses and other assets		64,043			36,690
Total current assets		913,311			666,438
Long-term investments		527,348			137,954
Property and equipment, net		73,203			88,516
Investments in non-consolidated companies		13,928			15,952
Debt issuance costs, net		14,965			6,037
Goodwill		347,616			113,327
Intangible assets, net		45,126			2,548
Restricted cash		6,000			6,000
Interest rate swap		11,557			17,378
Other assets, net		17,456			21,133
Total assets	$	1,970,510		$	1,075,283
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	17,584		$	12,292
Accrued liabilities		96,637			71,414
Deferred tax liabilities		27,925			—
Income taxes payable		35,404			70,051
Short-term deferred revenue		212,716			135,338
Total current liabilities		390,266			289,095
Convertible notes		811,159			316,972
Long-term deferred tax liabilities		266			—
Long-term deferred revenue		67,909			24,048
Other long-term payable		541			—
Total liabilities		1,270,141			630,115
Commitments and contingencies (Notes 8 and 9)
Stockholders’ equity:
Preferred stock: par value $0.002 per share, 5,000 shares authorized; no shares issued and outstanding		—			—
Common stock: par value $0.002 per share, 240,000 shares authorized; 90,481 and 84,694 shares issued and outstanding, respectively		181			169
Additional paid-in capital		468,150			254,218
Treasury stock: at cost; 784 and 784, respectively		(16,082	)		(16,082	)
Notes receivable from issuance of common stock		(6,580	)		(11,055	)
Unearned stock-based compensation		(1,533	)		(1,296	)
Accumulated other comprehensive loss		(6,219	)		(1,725	)
Retained earnings		262,452			220,939
Total stockholders’ equity		700,369			445,168
Total liabilities and stockholders’ equity	$	1,970,510		$	1,075,283

The accompanying notes are an integral part of these consolidated financial statements.

F-2

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

	Year ended December 31,
	2003			2002			2001
Revenues:
License fees	$	201,047		$	192,212		$	203,817
Subscription fees		98,858			53,024			32,783
Total product revenues		299,905			245,236			236,600
Maintenance fees		159,030			122,343			98,536
Professional service fees		47,538			32,543			25,864
Total revenues		506,473			400,122			361,000
Costs and expenses:
Cost of license and subscription		29,056			24,804			23,915
Cost of maintenance		11,880			11,662			10,712
Cost of professional services (excluding stock-based compensation)		36,889			24,334			20,396
Marketing and selling (excluding stock-based compensation)		238,765			193,775			182,682
Research and development (excluding stock-based compensation)		55,608			42,246			40,726
General and administrative (excluding stock-based compensation )		40,000			32,407			24,806
Stock-based compensation *		5,992			1,163			1,999
Acquisition related charges		11,968			—			—
Restructuring, integration and other related charges		3,389			(537	)		5,361
Amortization of goodwill and other intangible assets		7,470			2,375			30,125
Facilities impairment		16,882			—			—
Total costs and expenses		457,899			332,229			340,722
Income from operations		48,574			67,893			20,278
Interest income		34,720			35,119			36,981
Interest expense		(19,551	)		(23,370	)		(23,636	)
Net loss on investments in non-consolidated companies		(3,524	)		(5,296	)		—
Other income (expense), net		(2,524	)		8,043			17,113
Income before provision for income taxes		57,695			82,389			50,736
Provision for income taxes		16,182			17,185			16,582
Net income	$	41,513		$	65,204		$	34,154
Net income per share (basic)	$	0.48		$	0.78		$	0.41
Net income per share (diluted)	$	0.45		$	0.74		$	0.39
Weighted average common shares (basic)		87,124			83,938			82,559
Weighted average common shares and equivalents (diluted)		92,728			87,640			88,567
* Stock-based compensation:
Cost of professional services	$	53		$	—		$	—
Marketing and selling		5,609			643			998
Research and development		296			453			550
General and administrative		34			67			451
Total stock-based compensation	$	5,992		$	1,163		$	1,999

The accompanying notes are an integral part of these consolidated financial statements.

F-3

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

	Common stock					Additional paid-in			Treasury			Notes receivable from issuance of common			Unearned stock-based			Accumulated other comprehensive			Retained		Total stockholders’			Comprehensive
	Shares		Amount			capital			stock			stock			compensation			loss			earnings		equity			income (loss)
Balance at December 31, 2000	81,129		$	162		$	190,232		$	—		$	(7,528	)	$	—		$	(1,415	)	$	121,581	$	303,032
Repurchase of common stock	(784	)		(1	)		—			(16,082	)		—			—			—			—		(16,083	)
Unearned stock-based compensation	—			—			10,777			—			—			(10,436	)		—			—		341
Amortization of unearned stock-based compensation	—			—			—			—			—			1,659			—			—		1,659
Reversal of unearned stock-based compensation	—			—			(3,982	)		—			—			3,982			—			—		—
Tax benefit from stock options	—			—			6,118			—			—			—			—			—		6,118
Vested stock options assumed in conjunction with the Freshwater acquisition	—			—			850			—			—			—			—			—		850
Collection of notes receivable	—			—			—			—			400			—			—			—		400
Stock issued under stock option and employee stock purchase plans	2,504			5			28,755			—			(4,036	)		—			—			—		24,724
Currency translation adjustments	—			—			—			—			—			—			(850	)		—		(850	)	$	(850	)
Net income	—			—			—			—			—			—			—			34,154		34,154			34,154
Balance at December 31, 2001	82,849			166			232,750			(16,082	)		(11,164	)		(4,795	)		(2,265	)		155,735		354,345		$	33,304
Amortization of unearned stock-based compensation	—			—			—			—			—			1,163			—			—		1,163
Reversal of unearned stock-based compensation	—			—			(2,336	)		—			—			2,336			—			—		—
Collection of notes receivable	—			—			—			—			878			—			—			—		878
Stock issued under stock option and employee stock purchase plans	1,845			3			23,804			—			(769	)		—			—			—		23,038
Currency translation adjustments	—			—			—			—			—			—			540			—		540		$	540
Net income	—			—			—			—			—			—			—			65,204		65,204			65,204
Balance at December 31, 2002	84,694			169			254,218			(16,082	)		(11,055	)		(1,296	)		(1,725	)		220,939		445,168		$	65,744
Unearned stock-based compensation	—			—			1,571			—			—			(1,571	)		—			—		—
Amortization of stock-based compensation	—			—			—			—			—			787			—			—		787
Stock-based compensation for modification of stock options	—			—			5,205			—			—			—			—			—		5,205
Reversal of unearned stock-based compensation	—			—			(547	)		—			—			547			—			—		—
Tax benefit from stock options	—			—			6,367			—			—			—			—			—		6,367
Collection of notes receivable from officers	—			—			—			—			2,856			—			—			—		2,856
Collection of notes receivable from foreign employees	—			—			—			—			1,330			—			—			—		1,330
Repurchase of shares upon cancellation of notes receivable	(10	)		—			(289	)		—			289			—			—			—		—
Vested stock options assumed in conjunction with Kintana acquisition	—			—			38,325			—			—			—			—			—		38,325
Issuance of stock in conjunction with Kintana acquisition	2,237			5			88,528			—			—			—			—			—		88,533
Stock issued under stock option and employee stock purchase plans	3,560			7			74,772			—			—			—			—			—		74,779
Currency translation adjustments	—			—			—			—			—			—			(4,494	)		—		(4,494	)	$	(4,494	)
Net income	—			—			—			—			—			—			—			41,513		41,513			41,513
Balance at December 31, 2003	90,481		$	181		$	468,150		$	(16,082	)	$	(6,580	)	$	(1,533	)	$	(6,219	)	$	262,452	$	700,369		$	37,019

The accompanying notes are an integral part of these consolidated financial statements.

F-4

MERCURY INTERACTIVE CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

	Year ended December 31,
	2003			2002			2001
Cash flows from operating activities:
Net income	$	41,513		$	65,204		$	34,154
Adjustment to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		17,869			14,704			14,977
Sales reserves		1,193			3,342			3,384
Unrealized (gain) loss on interest rate swap		8			(406	)		—
Amortization of goodwill and other intangible assets		7,470			2,375			30,125
Stock-based compensation		5,992			1,163			1,999
Gain on early retirement of debt		—			(11,610	)		(19,833	)
Loss on investments in non-consolidated companies		3,959			5,296			—
Unrealized gain on a warrant		(435	)		—			—
Gain on sale of investments		—			—			(362	)
Non-cash restructuring charges		—			—			230
Write-off of in-process research and development		11,968			—			—
Facilities impairment		16,882			—			—
Tax benefit from stock options		6,367			—			6,118
Deferred income taxes		35,653			(6,595	)		5,734
Changes in assets and liabilities, net of effect of acquisitions:
Trade accounts receivable		(40,878	)		(28,288	)		(6,032	)
Prepaid expenses and other assets		(20,808	)		(27,498	)		(2,982	)
Accounts payable		3,167			(451	)		(752	)
Accrued liabilities		12,927			11,443			(1,731	)
Income taxes payable		(34,817	)		38,492			5,677
Deferred revenue		111,944			65,002			11,993
Other long-term payable		541			—			—
Net cash provided by operating activities		180,515			132,173			82,699
Cash flows from investing activities:
Maturities of investments		1,857,656			461,954			1,083,082
Purchases of investments		(2,225,649	)		(437,456	)		(867,315	)
Increase in restricted cash		—			(6,000	)		—
Purchases of investments in non-consolidated companies		(1,500	)		(2,244	)		(18,944	)
Cash paid in conjunction with Freshwater, net		—			—			(143,961	)
Cash paid in conjunction with Performant, net		(22,028	)		—			—
Cash paid in conjunction with Kintana, net		(136,653	)		—			—
Cash paid in conjunction with a technology purchase from Allerez		(1,270	)		—			—
Cash paid in conjunction with a domain name purchase		(650	)		—			—
Acquisition of property and equipment		(17,093	)		(8,164	)		(22,091	)
Net cash provided by (used in) investing activities		(547,187	)		8,090			30,771
Cash flows from financing activities:
Proceeds from issuance of convertible notes, net		488,056			—			—
Proceeds from issuance of common stock under stock option and employee stock purchase plans		74,779			23,038			24,724
Collection of notes receivable from issuance of common stock		4,186			878			400
Repurchase of treasury stock		—			—			(16,082	)
Retirement of convertible subordinated notes		—			(64,640	)		(100,024	)
Net cash provided by (used in) financing activities		567,021			(40,724	)		(90,982	)
Effect of exchange rate changes on cash		(194	)		1,287			(578	)
Net increase in cash and cash equivalents		200,155			100,826			21,910
Cash and cash equivalents at beginning of year		349,123			248,297			226,387
Cash and cash equivalents at end of year	$	549,278		$	349,123		$	248,297

The accompanying notes are an integral part of these consolidated financial statements.

F-5

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—OUR SIGNIFICANT ACCOUNTING POLICIES

We were incorporated in 1989 and began shipping testing products in 1991. Since 1991, we have introduced a variety of software products and services for Business Technology Optimization (BTO) including application delivery and application management. With our acquisition of Kintana in August 2003, we commenced sales of Information Technology (IT) governance products. Our software products and services for BTO help customers maximize the business value of IT by optimizing application quality and performance as well as managing IT costs, risks, and compliance.

In May 2001, we acquired all of the outstanding stock of Freshwater Software, Inc. In May and August of 2003, we also acquired Performant, Inc. and Kintana, Inc., respectively. These transactions were accounted for as purchases, and accordingly, the operating results of Freshwater, Performant, and Kintana have been included in our consolidated financial statements since the date of the acquisitions. See Note 5 for a full description of the acquisitions.

Basis of presentation

We have a wholly-owned research and development and sales subsidiary incorporated in Israel and sales subsidiaries in the Americas; Europe, the Middle East and Africa (EMEA); Asia Pacific (APAC); and Japan for marketing, distribution and support of products and services. The Americas includes Brazil, Canada, and the United States of America. EMEA includes Austria, Belgium, Denmark, Finland, France, Germany, Holland, Israel, Italy, Luxembourg, Norway, South Africa, Spain, Sweden, Switzerland, and the United Kingdom. APAC includes Australia, China, Hong Kong, India, Korea, and Singapore. The consolidated financial statements include our accounts and those of our wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated.

Use of estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Foreign currency translation

In preparing our consolidated financial statements, we are required to translate the financial statements of the foreign subsidiaries from the functional currency, generally the local currency, into U.S. dollars, the reporting currency. This process results in exchange gains or losses which, under the relevant accounting guidance are either included within the consolidated statements of operations or as a separate part of our net equity under the caption “Accumulated other comprehensive loss.” If any subsidiary’s functional currency is deemed to be the local currency, then any gain or loss associated with the translation of that subsidiary’s financial statements is reflected as cumulative translation adjustments included in accumulated other comprehensive income (loss). However, if the functional currency is deemed to be the U.S. dollar, any gain or loss associated with the translation of these financial statements is recorded as “Other income (expense), net” in our consolidated statements of operations.

The functional currency of our subsidiary in Israel is the U.S. dollar. Assets and liabilities in Israel are translated at year-end exchange rates, except for property and equipment, which is translated at historical rates. Revenues and expenses are translated at average exchange rates in effect during the year, except for costs related

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

to those balance sheet items, which are translated at historical rates. Foreign currency translation gains or losses are included in the consolidated statements of operations.

The functional currencies of all other subsidiaries are the local currencies. Accordingly, all assets and liabilities of these subsidiaries are translated at the current exchange rate at the end of the period and revenues and expenses at average exchange rates in effect during the period. The gains or losses from translation of these subsidiaries’ financial statements are recorded as accumulated other comprehensive income or loss and included as a separate component of stockholders’ equity.

Derivative financial instruments

We enter into derivative financial instrument contracts to hedge certain foreign exchange and interest rate exposures and have adopted Statement of Financial Accounting Standards (SFAS) No. 133, Accounting for Derivative Instruments and Hedging Activities. In June 2003, we adopted SFAS No. 149, Amendment of Statement 133 on Derivative Instruments Hedging Activities. This statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in SFAS No. 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the consolidated statement of cash flows. The provisions of this standard are effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS No. 149 are to be applied prospectively. The adoption of SFAS No. 149 did not have a material effect on our financial position and results of operations. See Note 13 for a full description of our derivative financial instruments and related accounting policies.

According to SFAS No. 133, we are required to recognize all derivatives on the consolidated balance sheets at fair value. Derivatives that are not hedges must be adjusted to fair value through the consolidated statements of operations. If the derivative is a hedge, depending on the nature of the hedge, changes in the fair value of derivatives will either be offset against the change in fair value of the hedged assets, liabilities or firm commitments through earnings, or recognized in other comprehensive income (loss) until the hedged item is recognized in earnings. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The accounting for gains or losses from changes in fair value of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship, as well as on the type of hedging relationship.

Financial instruments with characteristics of both liabilities and equity

In the second quarter of 2003, we adopted SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. This statement modifies the accounting for certain financial instruments that, under previous guidance, issuers could account for as equity. The new statement requires that those instruments be classified as liabilities in the statements of financial position. The adoption of this statement did not require us to make any reclassifications in our consolidated financial statements.

Cash and cash equivalents

We consider all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents.

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Short-term and long-term investments

We consider all investments with remaining maturities of less than one year to be short-term investments and all investments with remaining maturities greater than one year to be long-term investments. In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, we have categorized our marketable securities as “held to maturity” securities. The investments, which all have contractual maturities of less than three years, are carried at cost plus accrued interest.

The portfolio of short-term and long-term investments (including cash and cash equivalents) consisted of the following (in thousands):

	December 31,
Investment Type	2003		2002
Cash and interest bearing demand deposits	$	113,669	$	98,635
Corporate debt securities		225,690		421,693
Municipal and tax-advantaged securities		119,810		63,417
Auction rate preferred debt securities		298,949		—
U.S. treasury and agency securities		475,590		81,455
	$	1,233,708	$	665,200

The portfolio of short-term and long-term investments (including cash balance of $74.2 million) by their contractual maturities as of December 31, 2003 was included in the following captions in the consolidated balance sheet (in thousands):

	December 31,
	2004		2005		2006		Total		Fair Value
Cash and cash equivalents	$	549,278	$	—	$	—	$	549,278	$	549,344
Investments		157,082		130,571		396,777		684,430		686,999
	$	706,360	$	130,571	$	396,777	$	1,233,708	$	1,236,343

Concentration of credit risks

Financial instruments, which potentially subject us to concentrations of credit risk, consist principally of cash, cash equivalents, investments, and accounts receivable. We invest primarily in marketable securities and place our investments with high quality financial, government, or corporate institutions. Accounts receivable are derived from sales to customers located primarily in the U.S. and EMEA. We perform ongoing credit evaluations of our customers and to date have not experienced any material losses. For the years ended December 31, 2003, 2002, and 2001, no customer accounted for more than 10% individually of accounts receivable or revenue.

Fair value of financial instruments

The carrying amount of our financial instruments, including cash, cash equivalents, investments, accounts receivable and accounts payable approximates their respective fair values due to the short maturities of these financial instruments. The fair value of foreign currency forward contracts has been estimated using market quoted rates of foreign currencies at the applicable balance sheet dates. Warrants are valued using the Black-Scholes option-pricing model.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The fair market value of our Convertible Subordinated Notes issued in 2000 (2000 Notes) was $297.4 million and $269.3 million at December 31, 2003 and 2002, respectively, based on the quoted market price. The fair market value of our Zero Coupon Convertible Notes issued in 2003 (2003 Notes) was $574.5 million at December 31, 2003 based on the quoted market price.

Property and equipment

Property and equipment are stated at cost less accumulated depreciation. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of assets, which are five to seven years for office furniture and equipment, two to three years for computers and related equipment, three years for internal use software, four to five years for leasehold improvements or the term of the lease, whichever is shorter, seven to ten years for building improvements, and thirty years for buildings.

Internal use software

We recognize software development costs in accordance with the Statement of Position (SOP) No. 98-1, Accounting for the Costs of Computer Software Developed of Obtained for Internal Use. Software development costs, including costs incurred to purchase third party software, are capitalized beginning when we have determined certain factors are present including, among others, that technology exists to achieve the performance requirements, buy versus internal development decisions have been made. Capitalization of software costs ceases when the software is substantially complete, is ready for its intended use, and is amortized over its estimated useful life of generally three years using the straight-line method. At December 31, 2003 and 2002, we have capitalized internal use software of $16.2 million and $9.0 million, respectively. For the years ended December 31, 2003, 2002, and 2001, we incurred amortization expense of $2.8 million, $1.9 million, and $2.0 million, respectively.

When events or circumstances indicate the carrying value of internal use software might not be recoverable, we will assess the recoverability of these assets by determining whether the amortization of the asset balance over its remaining life can be recovered through undiscounted future operating cash flows. The amount of impairment, if any, is recognized to the extent that the carrying value exceeds the projected discounted future operating cash flows and is recognized as a write down of the asset. In addition, when it is no longer probable that computer software being developed will be placed in service, the asset will be recorded at the lower of its carrying value or fair value, if any, less direct selling costs. We did not write down any internal use software during the years ended December 31, 2003, 2002, and 2001.

Software costs

We account for research and development costs in accordance with SFAS No. 86, Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed. Costs incurred in the research and development of new software products are expensed as incurred until technological feasibility is established. Development costs are capitalized beginning when a product’s technological feasibility has been established and ending when the product is available for general release to customers. Technological feasibility is reached when the product reaches the working model stage. To date, products and enhancements have generally reached technological feasibility and have been released for sale at substantially the same time and all research and development costs have been expensed. Consequently, no research and development costs have been capitalized in 2003, 2002, and 2001.

Investments in non-consolidated companies

We make investments in early stage private companies and private equity funds for business and strategic purposes. These investments are accounted for under the cost method, as we do not have the ability to exercise

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

significant influence over these companies’ operations. We periodically monitor our investments for impairment and will record reductions in carrying values if and when necessary. The evaluation process is based on information that we request from these privately-held companies. This information is not subject to the same disclosure regulations as U.S. public companies, and as such, the basis for these evaluations is subject to the timing and the accuracy of the data received from these companies. As part of this evaluation process, our review includes, but is not limited to, a review of each company’s cash position, recent financing activities, financing needs, earnings/revenue outlook, operational performance, management/ownership changes, and competition. If we determine that the carrying value of an investment is at an amount above fair value, or if a company has completed a financing with new third-party investors based on a valuation significantly lower than the carrying value of our investment and the decline is other than temporary, it is our policy to record an investment loss in our consolidated statement of operations. In calculating the loss to be recorded, we take into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to outside third party investors.

Goodwill

Goodwill represents the excess of purchase price over fair value of tangible and intangible assets acquired in an acquisition. In January 2002, we adopted SFAS No. 142, Goodwill and Other Intangible Assets, and as a result, we ceased to amortize goodwill and reclassified certain intangible assets to goodwill. We are also required to perform an impairment review of goodwill on an annual basis or more frequently if circumstances change.

The impairment review involves a two-step process as follows:

• Step 1—We compare the fair value of our reporting units to the carrying value, including goodwill of each of these units. For each reporting unit where the carrying value, including goodwill, exceeded the unit’s fair value, we move on to Step 2. If the unit’s fair value exceeds the carrying value, no further work would be performed and no impairment charge would be necessary.

• Step 2—If we determine in Step 1 that the carrying value of a reporting unit exceeded our fair value, we would perform an allocation of the fair value of the reporting unit to our identifiable tangible and non-goodwill intangible assets and liabilities. This would derive an implied fair value for the reporting unit’s goodwill. We would then compare the implied fair value of the reporting unit’s goodwill with the carrying amount of the reporting unit’s goodwill. If the carrying amount of the reporting unit’s goodwill is greater than the implied fair value of our goodwill, an impairment loss would be recognized for the excess.

Intangible assets

Intangible assets, including purchased technology and other intangible assets, are carried at cost less accumulated amortization. We amortize intangible assets on a straight-line basis over their estimated useful lives. The range of estimated useful lives on our identifiable intangible assets is three months to six years.

Impairment of long-lived assets

We assess the recoverability of long-lived assets in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. The impairment of long-lived assets held for sale is measured at the lower of book value or fair value less cost to sell. The recoverability of long-lived assets held and used is assessed based on the carrying amount of the asset and its fair value, which is generally determined based on the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset, as well as specific appraisal in certain instances. Additionally, SFAS No. 144 expands the scope of discontinued

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operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. The adoption of SFAS No. 144 did not have a material impact on our financial position and results of operations.

We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important which could trigger an impairment review include the following:

• a significant decrease in the market price of a long-lived asset (asset group);

• a significant adverse change in the extent or manner in which a long-lived asset (asset group) is being used or in its physical condition;

• a significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset (asset group), including an adverse action or assessment by a regulator;

• an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset (asset group);

• a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset (asset group); and

• a current expectation that, more likely than not, a long-lived asset (asset group) will be sold or otherwise disposed of significantly before the end of its previously estimated useful life.

On September 30, 2003, we recorded an impairment charge of $16.9 million associated with our two vacant headquarters buildings. See Note 3—Consolidation of Facilities. No impairment charges were recorded in the years ended December 31, 2002 and 2001.

Income taxes

We account for income taxes in accordance with the liability method of accounting for income taxes. Under the liability method, deferred assets and liabilities are recognized based upon anticipated future tax consequences attributable to differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. The provision for income taxes is comprised of the current tax liability and the change in deferred tax assets and liabilities. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options.

Treasury stock

We account for treasury stock under the cost method. To date, we have not reissued or retired our treasury stock.

Stock-based compensation

We account for stock-based compensation for our employees using the intrinsic value method presented in Accounting Principles Board (APB) Statement No. 25, Accounting for Stock Issued to Employees, and related interpretations, and comply with the disclosure provisions of SFAS No. 123, Accounting for Stock-Based Compensation, and with the disclosure provisions of SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure Amendment of SFAS No. 123. Under APB No. 25, compensation expense is based on the difference, as of the date of the grant, between the fair value of our stock and the exercise

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price. No stock-based compensation was recorded for stock options granted to our employees because we have granted stock options to our employees equal to the price of the underlying stock on the date of grant. See Note 10 for discussion of unearned stock-based compensation. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and Emerging Issues Task Force (EITF) Issue No. 96-18, Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services. We do not issue stock options to non-employees, except for our non-employee members of our Board of Directors.

Pro forma information regarding net income (loss) and earnings (loss) per share is required by SFAS No. 123, as amended by SFAS No. 148. This information is required to be determined as if we had accounted for our employee stock option and employee stock purchase plans under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, to stock-based employee compensation (in thousands, except per share amounts):

	Year Ended December 31
	2003			2002			2001
Net income, as reported	$	41,513		$	65,204		$	34,154
Add:
Stock-based employee compensation expense included in reported net income		5,917			1,163			1,999
Deduct:
Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(141,723	)		(122,206	)		(113,949	)
Pro forma net loss	$	(94,293	)	$	(55,839	)	$	(77,796	)
Net income per share (basic), as reported	$	0.48		$	0.78		$	0.41
Net loss per share (basic), pro forma	$	(1.08	)	$	(0.67	)	$	(0.94	)
Net income per share (diluted), as reported	$	0.45		$	0.74		$	0.39
Net loss per share (diluted), pro forma	$	(1.08	)	$	(0.67	)	$	(0.94	)

We calculate stock-based compensation expense under the fair value based method for shares issued pursuant to the 1998 Employee Stock Purchase Plan (ESPP) based upon actual shares issued, except for the period since the most recent purchase in August 2003. We estimate the number of shares issuable under the 1998 ESPP based upon actual contributions made by employees for the period from August 16 through December 31, 2003 and the lower of the fair market value of our common stock on August 16 and December 31, 2003.

We amortize unearned stock-based compensation expense using the straight-line method over the vesting periods of the related options, which is generally four years for non-qualified and incentive stock options. Stock-based employee compensation expense determined under the fair value based method for non-qualified options issued pursuant to the stock option plans are tax affected. Stock-based employee compensation expense determined under the fair value based method for incentive stock options issued pursuant to the stock option plans and shares issued pursuant to the 1998 ESPP are not tax affected. See Note 10 for assumptions used in the option-pricing model and estimated fair value of employee stock options and shares issued under the 1998 ESPP.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Comprehensive income (loss)

We comply with SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 requires that all items recognized under accounting standards as components of comprehensive earnings be reported in an annual financial statement that is displayed with the same prominence as other annual financial statements. Comprehensive income has been included in the consolidated statements of stockholders’ equity for all periods presented.

Revenue recognition

Revenue consists of fees for license and subscription licenses of our software products, maintenance fees, and professional service fees. We apply the provisions of SOP No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9, Modification of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions, to all transactions involving the sale of software products and services. In addition, we apply the provisions of the EITF Issue No. 00-03, Application of AICPA SOP No. 97-2 to Arrangements that Include the Right to Use Software Stored on Another Entity’s Hardware, to our managed services software transactions. We also apply EITF No. 01-09, Accounting for Consideration Given by Vendor to a Customer or a Reseller of the Vendor’s Products to account for transactions related sales incentives.

In the second quarter of 2003, we adopted EITF No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which the vendor will perform multiple revenue-generating activities. The adoption of this EITF did not have a material impact on our consolidated financial statements and we continue to account for our revenues in accordance with SOP 97-2, Software Revenue Recognition.

License revenue is comprised of license fees charged for the use of our products licensed under perpetual or multiple year arrangements in which the fair value of the license fee is separately determinable from maintenance and/or professional services. We recognize revenue from the sale of software licenses when persuasive evidence of an arrangement exists, the product has been delivered, the fee is fixed or determinable, and collection of the resulting receivable is probable. Delivery generally occurs when product is delivered to a common carrier. At the time of the transaction, we assess whether the fee associated with our revenue transactions is fixed or determinable based on the payment terms associated with the transaction and whether or not collection is probable. If a significant portion of a fee is due after our normal payment terms, which are generally within 30-60 days of the invoice date, depending upon the region, we account for the fee as not being fixed or determinable. In these cases, we recognize revenue at the earlier of cash collection or as the fees become due. We assess collection based on a number of factors, including past transaction history with the customer. We do not request collateral from our customers. If we determine that collection of a fee is not probable, we defer the fee and recognize revenue at the time collection becomes probable, which is generally upon receipt of cash. For all sales, except those completed over the Internet, we use either a customer order document or signed license or service agreement as evidence of an arrangement. For sales over the Internet, we use a credit card authorization as evidence of an arrangement.

Subscription revenue, including managed service revenue, represents license fees to use one or more software products, and to receive maintenance support (such as hotline support and updates) for a limited period of time. Since subscription licenses include bundled products and services, both product and service revenue, which the fair value of the license fee is not separately determinable from maintenance, is generally recognized ratably over the term of the license. Customers do not pay a set up fee.

Maintenance revenue is comprised of fees charged for post-contract customer support, which are determinable based upon vendor specific evidence of fair value. Maintenance fee arrangements include ongoing customer support and rights to product updates “if and when available.” Payments for maintenance are generally

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

made in advance and are nonrefundable. They are recognized as revenue ratably over the period of the maintenance contract.

Professional service revenue is comprised of fees charged for product training and consulting services, which are determinable, based upon vendor specific evidence of fair value. They are recognized as revenue as the services are provided.

For arrangements with multiple elements (for example, undelivered maintenance and support), we allocate revenue to each component of the arrangement using the residual value method based on the fair value of the undelivered elements, which is specific to us. This means that we defer revenue from the arrangement fee equivalent to the fair value of the undelivered elements. Fair values for the ongoing maintenance and support obligations for our licenses are based upon renewal rates quoted in the contracts, and in the absence of stated renewal rates upon separate sales of renewals to other customers. Fair value of services, such as training or consulting, is based upon separate sales by us of these services to other customers. Most of our arrangements involve multiple elements. Our arrangements do not generally include acceptance clauses. However, if an arrangement includes an acceptance provision, acceptance occurs upon the earlier of receipt of a written customer acceptance or expiration of the acceptance period.

We derive a portion of our business from sales of our products through our alliance partners, which include value-added resellers, and major systems integration firms. We normally pay our alliance partners a fee for the referral, which is netted against revenue recognized.

In accordance with the provisions of APB Opinion No. 29, Accounting for Nonmonetary Transactions, we record barter transactions at the fair value of the goods or services provided or received, whichever is more readily determinable in the circumstances. For the years ended December 31, 2003, 2002, and 2001, revenue from barter transactions has been insignificant and represents less than 1% of total revenue.

Sales reserve

Our license agreements and reseller agreements do not offer our customers or vendors the unilateral right to terminate or cancel the contract and receive a cash refund. In addition, the terms of our license agreements do not offer customers price protection.

We do provide for sales returns based upon estimates of potential future credits, warranty cost of product and services, and write-offs of bad debts related to current period product revenues. We analyze historical credits, historical bad debts, current economic trends, average deal size, and changes in customer demand, and acceptance of our products when evaluating the adequacy of the sales reserve. Revenues for the period are reduced to reflect the sales reserve provision. See Note 2 for a summary of changes in our sales reserve during the years ended December 31, 2003 and 2002.

Cost of license and subscription, maintenance, and professional services

Cost of license and subscription includes direct costs to produce and distribute our products, such as costs of materials, product packaging and shipping, equipment depreciation and production personnel; and costs associated with our managed services business, including personnel related costs, fees to providers of internet bandwidth and related infrastructure and depreciation expense of managed services equipment. Cost of maintenance includes direct costs of providing product customer support, largely consisting of personnel costs and related expenses; and the cost of providing upgrades to our subscription customers. We have not broken out

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

the costs associated with subscriptions because these costs cannot be separated between license and subscription cost of revenue. Cost of professional services includes direct costs of providing product training and consulting, largely consisting of personnel costs and related expenses. License and subscription, maintenance and professional services costs also include allocated facility and infrastructure expenses.

Research and development

Research and development costs are expensed as incurred.

Acquisition related charges

We expense as incurred all costs associated with in-process research and development (IPR&D), provided that technological feasibility of IPR&D has not been established and no future alternative uses of the technology exist.

Advertising expense

We expense the costs of producing advertisements at the time production occurs, and expense the cost of communicating advertising in the period during which the advertising space or airtime is used. For the years ended December 31, 2003, 2002, and 2001, advertising expenses totaled $9.2 million, $5.9 million, and $5.6 million, respectively.

Net income per share

Earnings per share are calculated in accordance with the provisions of SFAS No. 128, Earnings per Share. SFAS No. 128 requires the reporting of both basic earnings per share, which is the weighted-average number of common shares outstanding, and diluted earnings per share, which includes the weighted-average number of common shares outstanding and all dilutive potential common shares outstanding, using the treasury stock method. For the years ended December 31, 2003, 2002, and 2001, dilutive potential common shares outstanding reflects shares issuable under our stock option plans.

The following table summarizes our earnings per share computations for the years ended December 31, 2003, 2002, and 2001 (in thousands, except per share amounts):

	Year ended December 31,
	2003		2002		2001
Numerator:
Net income	$	41,513	$	65,204	$	34,154
Denominator:
Denominator for basic net income per share—weighted average shares		87,124		83,938		82,559
Incremental common shares attributable to shares issuable under employee stock plans		5,604		3,702		6,008
Denominator for diluted net income per share—weighted average shares		92,728		87,640		88,567
Net income per share (basic)	$	0.48	$	0.78	$	0.41
Net income per share (diluted)	$	0.45	$	0.74	$	0.39

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

For the years ended December 31, 2003, 2002, and 2001, options to purchase 8,372,000 shares, 15,483,000 shares, and 5,990,000 shares of common stock, respectively, with a weighted average price of $55.40, $44.73, and $67.44, respectively, were considered anti-dilutive because the options’ exercise price was greater than the average fair market value of our common stock for the years then ended. For the years ended December 31, 2003, 2002, and 2001, common stock reserved for issuance upon conversion of the outstanding the 2000 Notes for 2,697,000, 2,697,000, and 3,393,000 shares, respectively, were not included in diluted earnings per share because the conversion would be anti-dilutive. When the 2003 Notes are required to be included in our EPS calculations, 9,673,050 shares would be included in both the basic and diluted weighted average common shares and equivalents for the net income per share calculation.

Segment reporting

We comply with the SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for the manner in which public companies report information about operating segments in annual and interim financial statements. We have four reportable segments: the Americas, EMEA, APAC, and Japan. These segments are organized, managed, and analyzed geographically and operate in one industry segment: the development, marketing, and selling of integrated application delivery, application management, and IT governance solutions. Our chief decision makers evaluate operating segment performance based primarily on net revenues and certain operating expenses. Information related to geographic segments is included in Note 16.

Reclassifications

Certain reclassifications have been made to the consolidated balance sheet as of December 31, 2002 to conform to the December 31, 2003 presentation, specifically the break out of current and long-term deferred tax assets and deferred tax liabilities and the netting of deferred tax assets and deferred tax liabilities from the same tax jurisdiction. Certain reclassifications have been made to the consolidated statements of operations for the years ended December 31, 2002 and 2001 to conform to the current year presentation, specifically the allocation of facility and information technology infrastructure expenses. The consolidated statement of cash flows for the year ended December 31, 2001 was modified, specifically the reclassification of tax benefit from stock options out of income tax payable and deferred income taxes.

Recent accounting pronouncements

In January 2003, the FASB issued Interpretation (FIN) No. 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin (ARB) No. 51, which relates to the identification of, and financial reporting for, variable-interest entities (VIEs). FIN No. 46 requires that if an entity is the primary beneficiary of a variable interest entity, the assets, liabilities and results of operations of the variable interest entity should be included in the consolidated financial statements of the entity. The provisions of FIN No. 46 are effective immediately for all arrangements entered into after January 31, 2003. For those arrangements entered into prior to February 1, 2003, the provisions of FIN No. 46 are required to be adopted at the beginning of the first interim or annual period beginning after June 15, 2003. In December 2003, FASB issued a revised FIN No. 46. The FASB deferred the effective date for VIEs that are non-special purpose entities created before February 1, 2003, to the first interim or annual reporting period that ends after March 15, 2004. We do not believe the adoption of FIN No. 46 will have a material impact on our financial position and results of operations.

F-16

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 2—FINANCIAL STATEMENT COMPONENTS

	December 31,
	2003			2002
	(in thousands)
Sales reserve:
Beginning balance	$	7,431		$	6,334
Increase in sales reserve (reduction in revenue)		1,193			3,342
Write-off of accounts receivable against reserve		(2,619	)		(2,370	)
Currency translation adjustments		112			125
Ending balance	$	6,117		$	7,431
	December 31,
	2003			2002
	(in thousands)
Property and equipment, net:
Land and buildings	$	55,272		$	60,256
Computers and equipment		44,668			37,249
Internal use software		16,194			9,002
Office furniture and equipment		13,747			12,319
Leasehold improvements		8,864			7,359
		138,745			126,185
Less: Accumulated depreciation and amortization		(67,378	)		(53,045	)
		71,367			73,140
Construction in progress		1,836			15,376
	$	73,203		$	88,516

Depreciation and amortization expense of property and equipment for the three years ended December 31, 2003, 2002, and 2001 was $14.4 million, $13.7 million, and $13.4 million, respectively. For the years ended December 31, 2003, 2002, and 2001, property and equipment acquired under capital leases were insignificant.

	December 31,
	2003		2002
	(in thousands)
Accrued liabilities:
Payroll and related	$	58,144	$	42,591
Interest on convertible subordinated notes		7,125		7,125
Sales tax and related		9,358		5,628
Unfavorable lease liabilities		4,284		—
Swap interest expense		1,174		3,673
Other		16,552		12,397
	$	96,637	$	71,414

F-17

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

	Year ended December 31,
	2003			2002			2001
	(in thousands)
Other income (expense), net:
Gain on early retirement of debt	$	—		$	11,610		$	19,833
Amortization of debt issuance costs		(3,018	)		(1,562	)		(2,085	)
Foreign exchange losses		(214	)		(1,867	)		—
Gain on interest rate swap		—			406			(214	)
Other		708			(544	)		(421	)
	$	(2,524	)	$	8,043		$	17,113

NOTE 3—CONSOLIDATION OF FACILITIES

In July 2003, the Board of Directors approved a plan to lease a new headquarter facility and to sell the existing buildings in our Sunnyvale headquarters. During September 2003, we signed a letter of intent to lease four buildings and material terms of the lease were finalized in the same month. The lease agreement was signed in October 2003. As a result of our decision to move to a new headquarter facility and to sell the buildings we vacated and plan to vacate, we performed an impairment analysis of the four buildings that comprise our Sunnyvale headquarters. In September 2003, we wrote down the net book value of our two existing vacant buildings to $2.7 million, which approximated their appraised market value after taking into account the cost to maintain these facilities until sold and sales commissions related to the sale of the buildings. Accordingly, we reclassified these two buildings as assets held for sale. Assets held for sale are included in “Prepaid expenses and other assets” in our consolidated balance sheet as of December 31, 2003. In addition, we recorded the related facilities impairment charge of $16.9 million for the two buildings in the consolidated statement of operations for the year ended December 31, 2003. We are currently using the remaining two buildings, as our new headquarter facility is not available for us to occupy until the second quarter of fiscal 2004. We have not recorded any impairment charges related to these buildings. See Note 17 for the sale of the two vacant buildings subsequent to December 31, 2003.

NOTE 4—INVESTMENTS IN NON-CONSOLIDATED COMPANIES

As of December 31, 2003, we had investments in non-consolidated companies of $13.9 million. Our investments in early stage private companies and a private equity fund were $13.5 million and the fair value of a warrant to purchase common stock of a private company was $0.4 million. At December 31, 2002, our investments in early stage private companies and a private equity fund were $16.0 million. We did not hold any warrants in fiscal 2002. Through December 31, 2003, we made capital contributions to a private equity fund totaling $6.4 million and we have committed to make additional capital contributions up to $8.6 million in the future. In calculating the loss to be recorded, we took into account the latest valuation of each of the portfolio companies based on recent sales of equity securities to outside third party investors. For the years ended December 31, 2003 and 2002, we recorded a loss of $3.5 million and $5.3 million, respectively, on three of our investments in early stage private companies. We also recorded a loss of $0.4 million on a private equity fund for the year ended December 31, 2003. We did not record any losses on our investments in early stage private companies and the private equity fund for the year ended December 31, 2001. We believe that the carrying value of our investments in non-consolidated companies approximate their fair value at December 31, 2003 and 2002.

On August 15, 2003, we received a warrant to purchase 500,000 shares of common stock of Motive, Inc. at $2.50 per share. The warrant expires on August 15, 2008. The warrant contains a net settlement provision and, as such, is treated as a derivative instrument in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 149, Amendment of Statement 133 on Derivative

F-18

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Instruments Hedging Activities. The fair value of the warrant is recorded in our consolidated balance sheet as “Investments in non-consolidated companies” and the change in fair value of the warrant was recorded as “Net loss on investments in non-consolidated companies” in our consolidated statement of operations. As of December 31, 2003, the fair value of the warrant was $0.4 million. During the year ended December 31, 2003, we recorded an unrealized gain of $0.4 million for the change in fair value of the warrant. We calculated the fair value of the warrant using the Black-Scholes option-pricing model with the following assumptions: risk-free interest rate of 3.25%, contractual life of 5 years, volatility of 53.70% and zero dividend rate. We had not exercised the warrant as of December 31, 2003.

NOTE 5—ACQUISITIONS

2003

Kintana

On August 15, 2003, we acquired Kintana, a leading provider of IT governance software and services. Kintana’s IT governance software expands our product line to include products which enable our customers to govern and manage the priorities, processes, and people required to run IT as a business.

The total purchase price of the Kintana merger was as follows (in thousands):

Cash	$	130,900
Fair value of Mercury common stock issued		88,533
Fair value of Mercury options issued		39,641
Direct merger costs incurred by Mercury		3,740
Direct merger costs incurred by Kintana to be paid by Mercury		4,646
Total purchase price	$	267,460

The fair value of our common stock issued was determined using the average closing price of our common stock for the 15 trading days up to and including August 13, 2003. The fair value of our options issued was determined using the Black-Scholes option-pricing model. We issued 2,236,926 shares of common stock based upon the number of shares of Kintana stock outstanding as of August 15, 2003, and the exchange ratio in accordance with the merger agreement. We also issued options to purchase 1,493,066 shares of our common stock in exchange for all Kintana options outstanding as of August 15, 2003.

We engaged a third party to assist us in the preparation of a valuation of the assets acquired. Based on the results of the valuation, the purchase price is allocated as follows (in thousands):

Cash	$	1,283
Tangible assets		8,990
Deferred tax asset		12,784
Liabilities assumed		(11,302	)
Deferred tax liability		(17,710	)
In-process research and development		10,688
Non-compete agreements		13,863
Current products and technology		13,376
Core technology		10,930
Maintenance and support contracts		6,106
Goodwill		217,135
Unearned stock-based compensation		1,317
Total purchase price	$	267,460

F-19

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

We recorded a deferred tax asset of $12.8 million primarily relating to net operating loss and tax credit carryforwards acquired as part of the acquisition. In addition, a deferred tax liability of $17.7 million was recorded for the difference between the assigned values and the tax bases of the intellectual property assets acquired in the acquisition.

The weighted average amortization period of non-compete agreements and current products and technology are 36 months, core technology is 60 months, and maintenance and support contracts are 72 months. The total weighted average amortization period of all intangible assets is 47 months. All intangible assets are amortized on a straight-line basis over their useful lives which best represents the distribution of the economic value of the intangible assets. Amortization expense for intangible assets acquired from Kintana for the year ended December 31, 2003 was $4.6 million. The estimated total amortization expense associated with acquired Kintana intangible assets is $12.3 million for each of 2004 and 2005, $8.9 million for 2006, $3.2 million for 2007, $2.4 million for 2008, and $0.6 million thereafter.

Goodwill of $217.1 million represents the excess of the purchase price over the fair market value of the net tangible and amortizable intangible assets acquired. Goodwill will not be amortized and will be tested for impairment at least annually.

In conjunction with the acquisition of Kintana, we recorded a $10.7 million charge for acquired IPR&D during the third quarter of 2003 because technological feasibility of the IPR&D had not been established and no future alternative uses existed. The IPR&D charge was recorded as “Acquisition related charges” in our consolidated statement of operations for the year ended December 31, 2003. The acquired IPR&D is related to the next generation of Kintana’s IT governance software products including changes to existing applications and the addition of new applications. The value of IPR&D was determined using the discounted cash flow approach. The expected future cash flow attributable to the in-process technology is discounted at 23%. This rate takes into account that the product leverages core and current technology found in the versions of the software, the increasing complexity and criticality of distributed software applications, the demand for faster turnaround of new distributed applications and enhancements, the expected growth in the industry, the continuing introduction of new functionality into the products, and the percentage of completion of approximately 35%. The IPR&D projects are currently expected to be completed within two to three months, and the estimated costs to complete the project are approximately $1.0 million during that time.

In conjunction with the acquisition of Kintana, we recorded unearned stock-based compensation totaling $1.3 million, which represents the intrinsic value of 1,493,066 options to purchase our common stock that we issued in exchange for Kintana unvested stock options. This amount is included in the total fair value of our options issued of $39.6 million. Unearned stock-based compensation is amortized over the remaining vesting period of the related options on a straight-line basis. During the year ended December 31, 2003, amortization of unearned stock-based compensation associated with these options was $0.2 million. The estimated amortization of unearned stock-based compensation is $0.4 million for each of 2004 and 2005, $0.3 million for 2006, and less than $0.1 million thereafter.

During the year ended December 31, 2003, we recorded $0.6 million in integration costs related to the Kintana acquisition, primarily for severance and consulting services.

The transaction was accounted for as a purchase and, accordingly, the operating results of Kintana have been included in our accompanying consolidated statements of operations from the date of acquisition. The following unaudited pro forma information presents the combined results of Mercury and Kintana as if the acquisition had occurred as of the beginning of 2003 and 2002, after applying certain adjustments, including amortization of

F-20

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

intangible assets, amortization of unearned stock-based compensation, rent expense adjustment associated with unfavorable operating leases assumed by us, and interest income, net of related tax effects. IPR&D of $10.7 million has been excluded from the following presentation (in thousands, except per share amounts):

	Year Ended December 31,
	2003		2002
	(unaudited)
Net revenues	$	534,914	$	444,647
Net income	$	38,441	$	53,900
Net income per share (basic)	$	0.44	$	0.63
Net income per share (diluted)	$	0.42	$	0.60

Performant

On May 5, 2003, we acquired all of the outstanding stock and assumed the unvested stock options of Performant, a provider of Java 2 Enterprise Edition (J2EE) diagnostics software. Performant’s technology pinpoints performance problems at the application code level. The Performant acquisition allows our customers to diagnose J2EE performance issues across the application delivery and management cycle from pre-production testing to production operations.

The total purchase price was $22.5 million and consisted of cash consideration of $21.9 million, net of cash acquired of $0.3 million, and transaction costs of $0.6 million. We engaged a third party to assist us in the preparation of a valuation of the assets acquired. The allocation of the purchase price is as follows (in thousands):

Tangible assets (net of cash acquired)	$	270
Deferred tax asset		2,800
Liabilities assumed		(1,190	)
Deferred tax liability		(1,180	)
Existing technology		1,620
In-process research and development		1,280
Patents and core technology		800
Employment agreements		720
Customer contracts and related relationships		150
Order backlog		80
Goodwill		17,154
Total purchase price	$	22,504

We recorded a deferred tax asset of $2.8 million relating to net operating loss and tax credit carryforwards acquired as part of the acquisition. In addition, a deferred tax liability of $1.2 million was recorded for the difference between the assigned values and the tax bases of the intellectual property assets acquired in the acquisition.

The weighted average amortization period of existing technology, patents and core technology, and customer contracts and related relationships are 48 months, employment agreements are 18 months, and order backlog is 3 months. The total weighted average amortization period of all intangible assets is 41 months. All intangible assets are amortized on a straight-line basis over their useful lives. Amortization expense for intangible assets acquired from Performant for the year ended December 31, 2003 was $0.8 million. The estimated total amortization expense associated with acquired Performant intangible assets is $1.0 million for 2004, $0.6 million for each of 2005 and 2006, and $0.2 million for 2007.

F-21

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In conjunction with the acquisition of Performant, we recorded a $1.3 million charge for acquired IPR&D during the second quarter of 2003 because technological feasibility of the IPR&D had not been established and no future alternative uses of the technology existed. The IPR&D charge was recorded as “Acquisition related charges” in our consolidated statement of operations for the year ended December 31, 2003. The acquired IPR&D is related to the development of the Microsoft version of the diagnostics software or .NET version. The value of IPR&D was determined through the discounted cash flow approach. The expected future cash flow attributable to the in-process technology was discounted at 29%, taking into account the percentage of completion of approximately 46%, the rate technology changes in the industry, product life cycles, the future markets, and various projects’ stage of development. The IPR&D projects are currently expected to be completed between the next six to twelve months and the estimated costs to complete the project are insignificant during that time.

In conjunction with the acquisition of Performant, we recorded unearned stock-based compensation totaling $0.3 million associated with approximately 9,300 unvested stock options that we assumed. The options assumed were valued using the Black- Scholes option-pricing model. During the year ended December 31, 2003, amortization of unearned stock-based compensation associated with these options was less than $0.1 million. We expect to amortize the remaining unearned stock-based compensation through 2007, which is over the remaining vesting periods of the related options.

The transaction was accounted for as a purchase and, accordingly, the operating results of Performant have been included in our accompanying consolidated statement of operations from the date of acquisition. The following unaudited pro forma information presents the combined results of Mercury and Performant as if the acquisition had occurred as of the beginning of 2003 and 2002, after applying certain adjustments, including amortization of intangible assets and amortization of unearned stock-based compensation and interest income, net of related tax effects. IPR&D of $1.3 million has been excluded from the following presentation (in thousands, except per share amounts):

	Year Ended December 31,
	2003		2002
	(unaudited)
Net revenues	$	506,604	$	400,653
Net income	$	40,152	$	58,928
Net income per share (basic)	$	0.46	$	0.70
Net income per share (diluted)	$	0.43	$	0.67

In conjunction with the acquisition of Performant, we committed to a license agreement for certain technology. The agreement was entered into in August 2000 and remains in effect until April 2018. The total estimated commitment is approximately $0.2 million, although the maximum commitment could reach approximately $0.8 million. As of December 31, 2003, no payments were made to Performant.

In conjunction with the acquisition of Performant, we entered into a milestone bonus plan related to certain research and development activities. The plan entitles each eligible employee to receive bonuses, in the form of cash payments, based on the achievement of certain performance milestones by applicable target dates through November 2004. The commitment will be earned equally over time as milestones are achieved and expensed as incurred. The maximum payments under the plan are $5.5 million. We recorded $2.8 million as “Restructuring, integration and other related charges” in our consolidated statement of operations for the year ended December 31, 2003 associated with the milestone bonus plan.

F-22

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

2002

There were no business acquisitions during fiscal 2002.

2001

Freshwater

In May 2001, we acquired all of the outstanding securities of Freshwater, a provider of eBusiness monitoring and management solutions. We acquired Freshwater for cash consideration of $146.6 million. In connection with this acquisition, we assumed net assets of $2.4 million (including cash acquired of $2.7 million) and recorded a deferred tax liability of $3.0 million. The purchase price included $0.8 million for the fair value of approximately 13,000 assumed Freshwater vested stock options, as well as direct acquisition costs of $0.5 million. The fair value of options assumed was estimated using the Black-Scholes option-pricing model with the following assumptions: fair value of $74.21 per share; expected life (years) of four; risk-free interest rate of 4.41%; volatility of 92%; and dividend yield of zero percent. The allocation of the purchase price resulted in an excess of purchase price over net tangible assets acquired of $148.1 million. This was allocated, based on a valuation we prepared with the assistance of a third party, $2.1 million to workforce, $5.5 million to purchased technology and $140.5 million to goodwill. Goodwill and other intangible assets were amortized on a straight-line basis over 3 years. Beginning January 1, 2002, goodwill is not amortized in accordance with SFAS 142 as discussed in Note 6. Amortization expense for the years ended December 31, 2003, 2002, and 2001 was $1.8 million, $2.4 million, and $30.1 million, respectively. We expect to amortize approximately $0.7 million of intangible assets in 2004.

In connection with the acquisition of Freshwater, we recorded unearned stock-based compensation totaling $10.4 million associated with approximately 140,000 unvested stock options that we assumed. The options assumed were valued using the fair market value of our stock on the date of acquisition, which was $74.21 per share. We also recorded stock-based compensation expense of $0.3 million in conjunction with the restructuring in 2001. The options were valued using the fair market value of our stock on the date of accelerated vesting, which was a weighted average of $32.92 per share. Amortization of unearned stock-based compensation was $0.6 million, $1.2 million and $1.7 million (excluding $341,000 of stock-based compensation expense) for the years ended December 31, 2003, 2002, and 2001, respectively. The estimated amortization of unearned stock-based compensation is $0.2 million for 2004 and less than $0.1 million in 2005.

The transaction was accounted for as a purchase and, accordingly, the operating results of Freshwater have been included in our accompanying consolidated statements of operations from the date of acquisition. If the purchase had occurred at the beginning of 2001, net revenues would have been $365.4 million in 2001; net income would have been $4.4 million; and earnings per share would have been $0.05.

NOTE 6—GOODWILL AND OTHER INTANGIBLE ASSETS

In May and August 2003, in conjunction with our acquisitions of Performant and Kintana, respectively, we acquired goodwill and intangible assets. See Note 5 for a full description of our acquisition activities. In addition, we purchased existing technology from Allerez in July 2003 and the Mercury.com domain name in October 2003.

In January 2002, SFAS No. 142, Goodwill and Other Intangible Assets, became effective and as a result, we ceased to amortize approximately $111.8 million of goodwill and reclassified $1.7 million of workforce to goodwill. We recorded approximately $29.0 million of amortization on these amounts during 2001. We also

F-23

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

wrote-off a deferred tax liability of $0.7 million associated with workforce against goodwill. In addition, we were required to perform a preliminary assessment of goodwill and an annual impairment review thereafter and potentially more frequently if circumstances change. We completed the preliminary assessment during the first quarter of 2002 and performed an annual impairment review during the fourth quarters of fiscal 2003 and 2002. We did not record an impairment charge as a result of our impairment reviews. We will continue to perform an annual impairment review every year and potentially more frequently if circumstances change.

During the fourth quarter of 2002, upon further review of SFAS No. 142, we reclassified $1.2 million of net intangible assets to goodwill. We had previously amortized goodwill of $0.2 million associated with these intangible assets in each of the first three quarters of 2002. We did not amortize this amount during the fourth quarter of 2002 and have ceased amortization associated with these intangible assets.

The changes in the carrying amount of goodwill are as follows (in thousands):

	Amount
Balance at December 31, 2001	$	111,789
Write-off of deferred tax liability associated with workforce		(661	)
Workforce, net of amortization		1,673
Excess facilities charge		1,069
Accumulated amortization		(543	)
Balance at December 31, 2002		113,327
Acquisition of Performant		17,154
Acquisition of Kintana		217,135
Balance at December 31, 2003	$	347,616

In the fourth quarter of 2003, we reduced our goodwill from the Kintana acquisition by $1.6 million, primarily due to additional cash received from Kintana and additional payments made subsequent to the close of the acquisition.

In the third quarter of 2003, we increased our goodwill from the Performant acquisition by $0.1 million, primarily due to additional transaction costs.

During the second quarter of 2002, we recorded a $1.1 million charge to goodwill for the additional estimated costs to sublease excess facilities in Boulder, Colorado in connection with the Freshwater acquisition. Upon completion of the acquisition, we were able to accurately estimate the costs to sublease these facilities by reviewing vacancy rates and current market conditions. This charge included $1.0 million for the remaining lease commitments of these facilities, net of the estimated sublease income throughout the duration of the lease term, and $0.1 million for the write-down of related leasehold improvements. During the fourth quarter of 2002, we increased the idle facility charge against net income by $0.1 million due to a change in estimate for the sublease start date. Cash payments of $0.4 million and $0.2 million were made in connection with this charge during the years ended December 31, 2003 and 2002, respectively. At December 31, 2003, our idle facility accrual was $0.6 million and is payable through 2006. Should facility rental rates continue to decrease in this market or should it take longer than expected to sublease these facilities, the actual loss could exceed these estimates.

F-24

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table presents the pro forma effects of SFAS No. 142, assuming we had adopted the standard as of January 1, 2001 (in thousands, except per share amounts):

	Year ended December 31,
	2003		2002		2001
Net income, as reported	$	41,513	$	65,204	$	34,154
Adjustments:
Amortization of goodwill		—		—		28,579
Amortization of workforce		—		—		427
Net income, as adjusted	$	41,513	$	65,204	$	63,160
Net income per share (basic), as reported	$	0.48	$	0.78	$	0.41
Net income per share (basic), as adjusted	$	0.48	$	0.78	$	0.77
Net income per share (diluted), as reported	$	0.45	$	0.74	$	0.39
Net income per share (diluted), as adjusted	$	0.45	$	0.74	$	0.71

The changes in the carrying amount of intangible assets are as follows (in thousands):

	December 31, 2003						December 31, 2002
	Gross Carrying Amount		Accumulated Amortization		Net		Gross Carrying Amount		Accumulated Amortization		Net
Intangible assets:
Existing technology	$	20,166	$	5,481	$	14,685	$	3,900	$	2,093	$	1,807
Patents and core technology		13,330		2,345		10,985		1,600		859		741
Maintenance and support contracts		6,106		382		5,724		—		—		—
Employment agreements		720		320		400		—		—		—
Customer contracts and other		14,093		1,838		12,255		—		—		—
Domain name		1,135		58		1,077		—		—		—
Total intangible assets	$	55,550	$	10,424	$	45,126	$	5,500	$	2,952	$	2,548

In July 2003, we purchased existing technology from Allerez for $1.3 million. This technology enables our customers to leverage their investment in their existing information technology infrastructure. The valuation of the intangible assets acquired was based upon our estimates supported by a valuation report prepared by an independent third-party valuation consultant. The intangible assets are amortized on a straight-line basis over their useful lives which best represent the distribution of the economic value of the intangible assets.

In October 2003, we purchased the Mercury.com domain name for $1.1 million. The total consideration consisted of $0.7 million in cash and $0.4 million in costs to provide certain customer support service and sales and technical training to the seller. The non-cash consideration was determined based upon our estimated costs to provide such services to third parties. The intangible assets will be amortized on straight-line basis or when services are performed.

The weighted average amortization period of existing technology is 38 months, patents and core technology is 56 months, employment agreements is 18 months, maintenance and support contracts are 72 months, customer contracts and other intangible assets are 36 months, and domain name is 60 months. The total weighted average amortization period of all intangible assets is 46 months. The aggregate amortization expense of intangible assets was $7.5 million, $2.4 million, and $1.1 million for the years ended December 31, 2003, 2002, and 2001. The estimated total amortization expense of intangible assets is $14.6 million for 2004, $13.5 million for 2005, $10.0 million for 2006, $3.8 million for 2007, $2.6 million for 2008, and $0.6 million thereafter.

F-25

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 7—LONG-TERM DEBT

In July 2000, we issued $500.0 million in Convertible Subordinated Notes. The 2000 Notes mature on July 1, 2007 and bear interest at a rate of 4.75% per annum, payable semiannually on January 1 and July 1 of each year. The 2000 Notes are subordinated in right of payment to all of our future senior debt. The 2000 Notes are convertible into shares of our common stock at any time prior to maturity at a conversion price of approximately $111.25 per share, subject to adjustment under certain conditions. We may redeem the 2000 Notes, in whole or in part, at any time on or after July 1, 2003. As of December 31, 2003, no 2000 Notes were redeemed. Accrued interest to the redemption date will be paid by us in any such redemption. During the year ended December 31, 2002, we paid $65.8 million including accrued interest of $1.2 million to retire $77.5 million face value of the Notes, which resulted in a gain on early retirement of debt of $11.6 million. From December 2001 through June 30, 2002, we retired $200.0 million face value of the 2000 Notes.

In connection with the issuance of our 2000 Notes, we incurred $14.6 million of issuance costs, which primarily consisted of investment banker fees, legal, and other professional fees. We wrote off $3.8 million of debt issuance costs as a result of the retirement of a portion of our 2000 Notes. The remaining costs are being amortized using the straight-line method over the remaining term of the 2000 Notes. Amortization expense related to the issuance costs was $1.4 million, $1.6 million, and $2.1 million for the years ended December 31, 2003, 2002, and 2001, respectively. At December 31, 2003 and 2002, net debt issuance costs associated with our 2000 Notes were $4.6 million and $6.0 million, respectively.

During the second quarter of 2002, we adopted SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 eliminates the requirement to classify gains and losses related to extinguishment of debt as extraordinary items, net of income taxes, unless they meet certain conditions. SFAS No. 145 was effective for fiscal years beginning after May 15, 2002, however early adoption was encouraged. As a result of the early adoption of SFAS No. 145, we have reclassified $11.6 million gain for the year ended December 31, 2002, as “Other income (expense), net” in our consolidated statement of operations.

In 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. See Note 13 for a full description of our derivative financial instruments and related accounting policies.

In April 2003, we issued $500.0 million of Zero Coupon Convertible Notes Due 2008 in a private offering. The 2003 Notes mature on May 1, 2008, do not bear interest, have a zero yield to maturity, and may be convertible into our common stock. Holders of the 2003 Notes may convert their 2003 Notes prior to maturity only:

• if during any fiscal quarter (beginning with the third fiscal quarter of 2003) the closing sale price of our common stock for at least 20 trading days in the 30 trading-day period ending on the last trading day of the immediately preceding fiscal quarter exceeds 110% of the conversion price of the 2003 Notes on that 30^th trading day;

• if during the period beginning January 1, 2008 through the maturity of the 2003 Notes, the closing sale price of our common stock on the previous trading day was 110% or more of the conversion price of the 2003 Notes on that previous trading day; or

• if specified corporate transactions have occurred; specified corporate transactions include:

i. we distribute to all holders of our common stock rights entitling them to purchase common stock at less than the average sale price of the common stock for the 10 trading days preceding the declaration date for such distribution; or

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ii. we elect to distribute to all holders of our common stock, cash or other assets, debt securities, or rights to purchase our securities, which distribution has a per share value exceeding 15% of the sale price of the common stock on the business day preceding the declaration date for the distribution, then at least 20 days prior to the ex-dividend date for the distribution we must notify the holders of the 2003 Notes in writing of the occurrence of such event. Once we have given that notice, holders may surrender their 2003 Notes for conversion at any time until the earlier of the close of business on the business day immediately prior to the ex-dividend date or the date of our announcement that the distribution will not take place, in the case of a distribution. No adjustment to the ability of a holder of 2003 Notes to convert will be made if the holder may participate in the distribution without conversion; or

iii. we are party to a consolidation, merger or binding share exchange pursuant to which our common stock would be converted into cash, securities or other property, a holder may surrender 2003 Notes for conversion at any time from and after the date which is 15 days prior to the anticipated effective date of the transaction until 15 days after the actual date of the transaction.

Upon conversion, we have the right to deliver cash instead of shares of our common stock. We may not redeem the 2003 Notes prior to their maturity.

In connection with the issuance of our 2003 Notes, we incurred $11.9 million of issuance costs, which primarily consisted of investment banker fees, legal, and other professional fees. These costs are being amortized using straight-line method over the term of the 2003 Notes. Amortization expense related to the issuance costs was $1.6 million for the year ended December 31, 2003. At December 31, 2003, net debt issuance costs associated with our 2003 Notes were $10.4 million.

NOTE 8—COMMITMENTS AND CONTINGENCIES

Royalty agreement

On June 30, 2003, we entered into a non-exclusive agreement to license technology from Motive. The agreement is non-transferable, except in the case of a merger, acquisition, spin-out or other transfer of all or substantially all of the business, stock or assets to which the agreement relates. The licensed technology will be combined with our other existing Mercury products, which should be generally available within twelve months from the effective date of this agreement. The agreement is in effect until December 31, 2005 with an election to renew and an option to purchase a fully paid up, perpetual license to the technology prior to July 1, 2008. We have committed to royalty payments totaling $15.0 million, which was originally due through June 15, 2004. As of December 31, 2003, we had paid $8.0 million and we recorded $11.0 million as prepaid royalties. Prepaid royalties are included as “Prepaid expenses and other assets” in our consolidated balance sheet and will be amortized to cost of license and subscription at the greater of the actual revenue over forecasted revenue or straight line over the estimated useful life. The remaining balance of $4.0 million will be paid by June 15, 2004. See Note 17 for amendment to the agreement entered into in February 2004 and payment made subsequent to December 31, 2003.

Executive severance

In December 2003, we entered into a severance agreement with a former executive officer. In accordance with the agreement, the former executive officer is entitled to salary and bonus through October 3, 2005. Under the agreement, we also modified terms of certain options granted to this officer (See Note 10). Severance charge related to accrued salaries and bonuses of $1.5 million was recorded as “Marketing and selling expense” in our consolidated statement of operations for the year ended December 31, 2003.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Lease commitments

We lease facilities for sales offices in the U.S. and foreign locations under non-cancelable operating leases that expire through 2015. Certain of these leases contain renewal options. We lease certain equipment under various leases with lease terms ranging from month-to-month up to one year. Future minimum payments under the facilities and equipment leases with non-cancelable terms in excess of one year are as follows as of December 31, 2003 (in thousands):

Year ending December 31,
2004	$	16,270
2005		14,840
2006		9,823
2007		7,080
2008		5,786
Thereafter		24,897
	$	78,696

Total rent expense under operating leases amounted to $8.4 million, $6.9 million, and $6.2 million for the years ended December 31, 2003, 2002, and 2001, respectively.

Letters of credit

As of December 31, 2003, we had four irrevocable letter of credit agreements totaling $1.4 million in conjunction with our facility leases. See Note 15 for a full description of the letters of credit.

Contingencies

From time to time, we may have certain contingent liabilities that arise in the ordinary course of our business activities. We accrue for contingent liabilities when it is probable that future expenditures will be made and such expenditures can be reasonably estimated. In the opinion of management, there are no pending claims of which the outcome is expected to result in a material adverse effect in our financial position, results of operations, or our statements of cash flows.

NOTE 9—GUARANTEES

In November 2002, the FASB issued FIN No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an Interpretation of FASB Statements No. 5, 57, and 107 and rescission of FIN No. 34. The Interpretation requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken by issuing the guarantee. FIN No. 45 also requires additional disclosures to be made by a guarantor in its interim and annual financial statements for periods ending after December 15, 2002 about its obligations under certain guarantees it has issued. The accounting requirements for the initial recognition of guarantees are applicable on a prospective basis for guarantees issued or modified after December 31, 2002. The adoption of FIN No. 45 did not have a material effect on our consolidated financial statements. The following is a summary of the agreements that we have determined are within the scope of FIN No. 45:

As permitted under Delaware law, we have agreements whereby our officers and directors are indemnified for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The term of the indemnification period is for the officer’s or director’s term in such capacity. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2003.

We enter into standard indemnification agreements in the ordinary course of business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners, subsidiaries and/or customers, in connection with any U.S. patent or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2003.

We may, at our discretion and in the ordinary course of business, subcontract the performance of any of our services. Accordingly, we enter into standard indemnification agreements with our customers, whereby our customers are indemnified for other acts, such as personal property damage, of our subcontractors. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have general and umbrella insurance policies that enable us to recover a portion of any amounts paid. We have not incurred significant costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we believe the estimated fair value of these agreements is insignificant. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2003.

When, as part of an acquisition, we acquire all of the stock or all of the assets and liabilities of a company, we assume the liability for certain events or occurrences that took place prior to the date of acquisition. Obligations relating to acquisitions made before December 31, 2002 were grandfathered under the provisions of FIN No. 45. We are not aware of any potential obligations arising as a result of acquisitions made subsequent to December 31, 2002 and we are therefore unable to determine the maximum potential payments we could be required to make for such obligations at this time. Accordingly, we have no liabilities recorded for these types of agreements as of December 31, 2003.

We have arrangements with certain vendors whereby we guarantee employee expenses. The term is from execution of the arrangement until cancellation and payment of any outstanding amounts. We would be required to pay any unsettled employee expenses upon notification from the vendor. The maximum potential amount of future payments we could be required to make under these indemnification agreements is insignificant. As a result, we believe the estimated fair value of these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2003.

We warrant our software products will perform in all material respects in accordance with our standard published specifications in effect at the time of delivery of the licensed products to the customer for the life of the product. Additionally, we warrant that our maintenance services will be performed consistent with generally accepted industry standards through completion of the agreed upon services. If necessary, we would provide for the estimated cost of product and service warranties based on specific warranty claims and claim history, however, we have not incurred significant expense under our product or services warranties. As a result, we

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

believe the estimated fair value on these agreements is minimal. Accordingly, we have no liabilities recorded for these agreements as of December 31, 2003.

NOTE 10—STOCKHOLDERS’ EQUITY

Preferred Stock

Under the terms of our Amended Articles of Incorporation, the Board of Directors may determine the rights, preferences, and terms of our authorized but unissued shares of preferred stock.

1989 Plan

In August 1989, we adopted a stock option plan (1989 Plan). Options granted under the 1989 Plan are for periods not to exceed ten years. For holders of 10% or more of the total combined voting power of all classes of our stock, options may not be granted at less than 110% of the fair value of the common stock at the date of grant and the option term may not exceed 5 years. Incentive stock option grants under the 1989 Plan must be at exercise prices not less than 100% of the fair market value and non-statutory stock option grants under the 1989 Plan must be at exercise prices not less than 85% of the fair market value of the stock on the date of grant. Options are immediately exercisable but all shares purchased upon exercise of options are subject to repurchase by us until vested. Options generally vest over a period of four years. Options are no longer granted under this plan.

1994 Director Plan

On August 3, 1994, the Board of Directors (Board) adopted the 1994 Directors’ Stock Option Plan (Directors’ Plan). We reserved 2,000,000 shares of common stock for issuance upon exercise of stock options to be granted during the ten-year term of the Directors’ Plan. Only members of the Board may be granted options under the Directors’ Plan. The plan provided for an initial option grant of 25,000 shares to our outside directors as of August 3, 1994 or upon initial election to the Board after August 3, 1994. In addition, the Directors’ Plan provided for automatic annual grants of 5,000 shares upon re-election of the individual to the Board. In August 1998, the stockholders agreed to amend the Directors’ Plan to increase the number of shares granted to 50,000 shares as an initial grant to new non-employee directors, 10,000 shares as the annual grant to continuing non-employee directors, and to provide for a one-time grant of 100,000 shares to our non-employee directors who were serving as our directors as of August 14, 1998. The option term is ten years, and options are exercisable while such person remains a director. The exercise price is not less than 100% of fair market value on the date of grant. The initial option grants and the one-time grants vest 20% annually for each director on the date of each Annual Meeting of Stockholders after the date of grant of such option. The annual option grants shall vest in full on the fifth anniversary following each individual’s re-election to the Board.

1996 Supplemental Plan

In May 1996, we adopted a stock option plan solely for grants to employees of our subsidiaries located outside the U.S. (Supplemental Plan). The provisions of the Supplemental Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1989 Plan. Options are no longer granted under this plan.

1999 Plan

In August 1998, the stockholders adopted the 1999 Stock Option Plan (1999 Plan) to replace the 1989 Plan, effective on the expiration of the term of such plan in August 1999. We reserved 900,000 shares of common

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

stock for issuance upon exercise of stock options to be granted under this plan. The provisions of the 1999 Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1989 Plan except that all options granted under the 1999 Plan must be at exercise prices not less than 100% of the fair market value. In December 1999, the stockholders approved an automatic increase in the aggregate number of shares reserved for issuance under the 1999 Plan of 4% of the common stock and equivalents outstanding as of January 1 of each year starting in 2000 and ended in 2003. In 2003, 2002, and 2001, the 1999 Plan shares reserved were automatically increased by 4,125,549, 3,995,750, and 3,879,728 shares, respectively. In December 2003, the stockholders approved to reserve an additional 3,000,000 shares for issuance under the 1999 Plan.

2000 Plan

In July 2000, we adopted the 2000 Supplemental Stock Option Plan (2000 Plan) which allows options to be granted to any employee who is not a U.S. citizen or resident and who is not an executive officer or director. We reserved 2,000,000 shares of common stock for issuance upon exercise of stock options to be granted under the 2000 Plan. In February 2001, the Board approved the reservation of an additional 4,000,000 shares. In November 2000, the Board amended and restated the 2000 Plan to better address our tax issues and our employees in countries other than the U.S. The provisions of the 2000 Plan regarding option term, grant price, and exercise price are identical to those of the 1999 Plan except that all the terms of options granted in certain EMEA countries may be different and the 2000 Plan provides for the grant of stock purchase rights.

1997 Freshwater Plan

In May 2001, in conjunction with the acquisition of Freshwater, we assumed the 1997 Freshwater Stock Option Plan (1997 Freshwater Plan). The provisions of the 1997 Freshwater Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan. Freshwater vested and unvested options were converted to our shares at a conversion ratio of 0.1326. Options are no longer granted under this plan.

Kintana Plans

In August 2003, in conjunction with the acquisition of Kintana, we assumed the Kintana 1997 Equity Incentive Plan in the U.S. and Share Option Scheme in the United Kingdom (Kintana Plans). The provisions of the Kintana Plans regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan except for stock options granted under the Share Option Scheme are not exercisable immediately. Kintana vested and unvested options were converted to options to purchase our shares at a conversion ratio of 0.0951. Options are no longer granted under these plans.

2000 Performant Plan

In May 2003, in conjunction with the acquisition of Performant, we assumed the 2000 Performant Stock Option Plan (2000 Performant Plan). The provisions of the 2000 Performant Plan regarding option term, grant price, exercise price, and vesting period are identical to those of the 1999 Plan. Performant unvested options were converted to options to purchase our shares at a conversion ratio of 0.0099. Options are no longer granted under this plan.

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MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Option plans summary

The following table presents the combined activity of all our option plans for the years ended December 31, 2003, 2002, and 2001 (shares in thousands):

	Options available for grant		Options outstanding
			Number of Shares		Weighted average exercise price
Balance outstanding at December 31, 2000	2,627		17,395		$	30.92
Additional shares authorized	7,880		—		$	—
Options granted	(5,593	)	5,593		$	40.05
Options canceled	981		(1,069	)	$	45.49
Options exercised	—		(2,328	)	$	8.68
Balance outstanding at December 31, 2001	5,895		19,591		$	35.32
Additional shares authorized	3,996		—		$	—
Options granted	(6,113	)	6,113		$	29.33
Options canceled	1,447		(1,587	)	$	45.21
Options exercised	—		(1,456	)	$	10.11
Balance outstanding at December 31, 2002	5,225		22,661		$	34.62
Additional shares authorized	7,126		—		$	—
Options assumed in acquisitions	—		1,502		$	36.42
Options granted	(6,232	)	6,232		$	34.43
Options canceled	1,501		(1,771	)	$	40.29
Options exercised	—		(3,034	)	$	20.97
Balance outstanding at December 31, 2003	7,620		25,590		$	35.90

The following table presents weighted average price and remaining contractual life information about significant option groups outstanding under the above plans at December 31, 2003 (shares in thousands):

	Options outstanding				Options vested
Range of exercise prices	Number outstanding	Weighted average remaining contractual life (years)	Weighted average exercise price		Number exercisable	Weighted average exercise price
$  0.40 – 18.25	4,107	4.67	$	9.75	3,932	$	9.46
$18.74 – 24.29	834	7.82		21.76	338		21.42
$25.41 – 29.29	3,734	7.44		29.01	1,713		29.14
$29.65 – 31.41	3,933	8.72		31.21	147		31.17
$31.55 – 39.81	4,610	8.64		35.95	1,088		33.04
$40.72 – 59.25	3,672	6.25		42.88	2,902		42.02
$60.88 – 125.44	4,700	6.45		65.17	3,752		65.33
	25,590	7.07		35.90	13,872		36.18

Employee Stock Purchase Plan

In August 1998, the stockholders adopted the 1998 Employee Stock Purchase Plan (1998 ESPP) and reserved 1,300,000 shares for issuance thereunder. In May 2002 and 2000, the stockholders approved the

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

reservation of an additional 500,000 shares in each year, respectively, for issuances under the 1998 ESPP. In December 2003, the stockholders approved to reserve an additional 5,000,000 shares for issuance under the 1998 ESPP. Under the 1998 ESPP, employees are granted the right to purchase shares of common stock at a price per share that is the lesser of (i) 85% of the fair market value of the shares at the participant’s entry date into the offering period, or (ii) 85% of the fair market value of the shares at the end of the offering period. In August 2001, the Board changed the offering period from six months to two years. During 2003, 2002, and 2001, 526,000, 389,000, and 176,000 shares, respectively, were purchased under the 1998 ESPP at an average purchase price of $21.23, $23.81, and $44.33, respectively.

Employee Benefit Plan

We have a qualified 401(k) plan available to eligible employees. Participants may contribute up to 15% of their annual compensation to the plan, limited to a maximum annual amount set by the Internal Revenue Service. We match employee contributions dollar for dollar up to a maximum of $1,000 per year per person. Matching contributions vest according to the number of years of employee service. We contributed and expensed $793,000, $603,000, and $568,000 to the 401(k) plan during 2003, 2002, and 2001, respectively.

Stock Repurchase Program

During the third quarter of 2001, the Board authorized the repurchase of 1 million shares of our common stock in the open market, subject to normal trading restrictions, at a price no greater than $25.00. The repurchased shares will be used for general corporate purpose, including the share issuance requirements under our employee stock option and purchase plans. At December 31, 2003 and 2002, we had 0.8 million shares of treasury stock at a cost of $16.1 million for both years.

Unearned Stock-Based Compensation

Unearned stock-based compensation was related to assumed stock options in conjunction with the acquisitions of Kintana and Performant in 2003 and Freshwater in 2001. Acquisition-related unearned stock-based compensation includes the intrinsic value of stock options assumed in conjunction with the acquisitions that is earned as the employees provide future services. Unearned stock-based compensation is amortized to expense over the remaining vesting period of the related options on a straight-line basis. Through December 31, 2003, we reduced unearned stock-based compensation by $6.9 million due to the termination of certain employees. The estimated amortization of unearned stock-based compensation is $0.8 million for 2004, $0.4 million for 2005, $0.3 million for 2006, and less than $0.1 million for 2007.

In December 2003, in connection with a severance agreement with a former executive officer, we extended the exercise period of options to purchase 350,000 shares of common stock and accelerated the vesting of options to purchase 374,479 shares of common stock at exercise prices ranging from $29.29 to $60.88. As of result of the modification of stock options, we recorded a one-time stock-based compensation charge of $5.1 million based on the fair value of our common stock on the date of the modification.

During the third quarter of 2003, we recorded a one-time stock-based compensation charge of $0.1 million as we modified original terms of certain options.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Fair Value and Assumptions for SFAS No. 123 Pro Forma Disclosures

The fair value of options and shares issued pursuant to the 1998 ESPP at the grant date were estimated using the Black-Scholes option-pricing model with the following weighted average assumptions for the years ended December 31, 2003, 2002, and 2001:

	Option plans						ESPP
	2003		2002		2001		2003		2002		2001
Expected life (years)	3.98		4.00		4.00		0.50		0.50		0.50
Risk-free interest rate	3.05	%	4.18	%	4.60	%	1.64	%	3.84	%	4.60	%
Volatility	89	%	90	%	92	%	89	%	90	%	92	%
Dividend yield	0.0	%	0.0	%	0.0	%	0.0	%	0.0	%	0.0	%

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of our options. Based upon the above assumptions, the weighted average fair valuation per share of options granted under the option plans during the years ended December 31, 2003, 2002, and 2001 was $22.52, $19.44, and $27.03, respectively. The weighted average fair valuation per share of stock granted under the 1998 ESPP during the years ended December 31, 2003, 2002, and 2001 was $12.70, $13.54 and $22.49, respectively.

NOTE 11—INCOME TAXES

The provision for income taxes consisted of (in thousands):

	Year Ended December 31,
	2003			2002			2001
Federal:
Current	$	137		$	12,095		$	5,436
Deferred		10,301			(5,915	)		1,519
		10,438			6,180			6,955
State:
Current		(1,841	)		2,087			2,232
Deferred		1,922			(680	)		225
		81			1,407			2,457
Foreign:
Current		(14,590	)		9,598			7,170
Deferred		20,253			—			—
		5,663			9,598			7,170
	$	16,182		$	17,185		$	16,582

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Income before provision for income taxes consisted of (in thousands):

	Year Ended December 31,
	2003			2002			2001
Domestic	$	(64,821	)	$	(59,213	)	$	(4,310	)
Foreign		122,516			141,602			55,046
	$	57,695		$	82,389		$	50,736

The provision for income taxes differs from the amount obtained by applying the statutory federal income tax rate to income before taxes as follows (in thousands):

	December 31,
	2003			2002			2001
Provision at federal statutory rate	$	20,193		$	28,837		$	17,776
State tax, net of federal tax benefit		81			1,407			1,689
Foreign rate differentials		(14,057	)		(13,109	)		(11,149	)
Reversal of valuation allowance		—			—			(1,705	)
Tax-exempt interest		(787	)		(575	)		(2,012	)
Non-deductible goodwill		3,003			—			10,002
Non-deductible in-process research and development		4,907			—			—
Non-deductible stock-based compensation		2,457			—			—
Other		385			625			1,981
	$	16,182		$	17,185		$	16,582

U.S. income taxes and foreign withholding taxes were not provided for on a cumulative total of $482.4 million of undistributed earnings for certain non-U.S. subsidiaries. We intend to invest these earnings indefinitely in operations outside the U.S. The components of the deferred tax assets (liabilities) follow (in thousands):

	December 31,
	2003			2002
Deferred tax assets:
Other reserves and accruals	$	13,195		$	2,054
Depreciation and amortization		5,133			2,940
Sales reserve		2,167			2,676
Accrued vacation		2,345			1,249
Amortization of goodwill		—			939
Research and development tax credits		948			—
Net operating loss		23,349			—
		47,137			9,858
Deferred tax liabilities:
Deferred intercompany payments		(58,571	)		(451	)
Acquired intangible assets		(16,757	)		—
		(75,328	)		(451	)
	$	(28,191	)	$	9,407

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

At December 31, 2001, we reversed our valuation allowance originating from net operating losses of foreign jurisdictions on certain deferred tax assets. We reversed the valuation allowance because we believe it is more likely than not that all deferred tax assets will be realized in the foreseeable future.

At December 31, 2003 and 2002, our U.S. net operating loss carryforwards for income tax purposes were approximately $223.7 million and $160.5 million, respectively. If not utilized, the Federal net operating loss carryforwards will expire in various years through 2023, and the States net operating loss carryforwards will expire in various years through 2013. The net operating losses are primarily attributable to stock option compensation deductions. We have recorded a valuation allowance for the entire portion of the net operating losses related to the income tax benefits arising from the exercise of employees’ stock options. We have established this valuation allowance because, in our best assessment, it is more likely than not that we will not recognize the tax benefit relating to these net operating loss carryovers.

In 2003, we recognized a tax benefit of $6.4 million relating to stock option deductions. This tax benefit was directly allocated to contributed capital.

As a result of ownership changes in Performant, approximately $10.0 million of net operating loss carryovers that relate to the Performant acquisition are subject to certain limitations under the U.S. Internal Revenue Code and State tax laws.

The earnings from foreign operations in Israel are subject to a lower tax rate pursuant to “Approved Enterprise” incentives effective through 2014. The incentives provide for certain tax relief if certain conditions are met. We believe that we continued to be in compliance with these conditions at December 31, 2003.

In 2002, we sold the economic rights of Freshwater’s intellectual property to our Israeli subsidiary. As a result of this intellectual property sale, we recorded a current tax payable and a prepaid tax asset in the amount of $25.5 million, which will be amortized to income tax expense over eight years, which approximates the period over which the expected benefit is expected to be realized. At December 31, 2003, we have a prepaid tax asset of $3.2 million included in prepaid expenses and $15.9 million included in net other assets.

In 2003, approximately $2.8 million and $8.4 million of our deferred tax assets are attributes acquired in the Performant and Kintana transactions, respectively. The recognition of the tax benefit that relates to these assets was allocated directly to reduce goodwill from the respective transaction. Additionally, in connection with these transactions, deferred tax liabilities of $0.9 million and $15.9 million were established as part of the transaction purchase accounting for the Performant and Kintana acquisitions, respectively. These deferred tax liabilities relate to the amortizable identifiable intangibles in which we have no tax basis.

NOTE 12—DERIVATIVE FINANCIAL INSTRUMENTS

We have entered into forward contracts to hedge foreign currency denominated deferred revenues and receivables due from certain subsidiaries and foreign branches in the Americas, EMEA, APAC, and Japan against fluctuations in exchange rates. We have not entered into forward contracts for speculative or trading purposes. The criteria used for designating a forward contract as a hedge considers its effectiveness in reducing risk by matching hedging instruments to underlying transactions. Gains or losses on forward contracts are recognized as other income (expense) in the same period as gains or losses on the underlying transactions. We had outstanding forward contracts with notional amounts totaling $31.5 million and $17.5 million at December 31, 2003 and 2002, respectively. The forward contracts in effect at December 31, 2003 mature at various dates through December 2004 and are hedges of certain foreign currency transaction exposures in the British Pound,

F-36

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Canadian Dollar, Danish Kroner, Euro, Japanese Yen, Norwegian Kroner, Singapore Dollar, South African Rand, and Swiss Franc.

We utilize forward exchange contracts of one fiscal-month duration to offset various non-functional currency exposures. Currencies hedged under this program include the Australian Dollar, Canadian Dollar, British Pound, Euro, Israeli Shekel, and Swedish Kroner. Increases or decreases in the value of these non-functional currency assets are offset by gains or losses on the forward exchange contracts to mitigate the risk associated with foreign exchange market fluctuations. We had outstanding forward contracts with notional amounts totaling $42.6 million at December 31, 2003. There were no forward contracts outstanding at December 31, 2002. These forward exchange contracts contain credit risk in that the counterparties may be unable to meet the terms of the agreements. However, we minimize such risk of loss by limiting these agreements to major financial institutions. We also monitor closely the potential risk of loss with any one financial institution. We do not expect any material losses as a result of default by counterparties.

In January 2002 and February 2002, we entered into two interest rate swaps with respect to $300.0 million of our 2000 Notes. In November 2002, we terminated our January and February interest rate swaps with Goldman Sachs Capital Markets, L.P. (GSCM) and replaced them with a single interest rate swap in order to improve the overall effectiveness of our interest rate swap arrangement. The November interest rate swap with a maturing date of July 2007, is designated as an effective hedge of the change in the fair value attributable to the London Interbank Offering Rate (LIBOR) relating to $300.0 million of our 2000 Notes. The objective of the swap is to convert the 4.75% fixed interest rate on the 2000 Notes to a variable interest rate based on the 6-month LIBOR plus 46.0 basis points. Beginning in January 2003, the variable interest rate on the swap was modified so that it is now based on the 3-month LIBOR plus 48.5 basis points. The gain or loss from changes in the fair value of the interest rate swap is expected to be highly effective at offsetting the gain or loss from changes in the fair value of the 2000 Notes attributable to changes in the LIBOR throughout the life of the 2000 Notes. The interest rate swap creates a market exposure to changes in the LIBOR. Under the terms of the swap, we are required to provide initial collateral in the form of cash or cash equivalents to GSCM in the amount of $6.0 million as continuing security for our obligations under the swap (irrespective of movements in the value of the swap) and from time to time additional collateral can change hands between Mercury and GSCM as swap rates and equity prices fluctuate. We accounted for the initial collateral and any additional collateral as restricted cash on our consolidated balance sheets. If the price of our common stock exceeds the original conversion or redemption price of the 2000 Notes, we will be required to pay the fixed rate of 4.75% and receive a variable rate on the $300.0 million principal amount of the 2000 Notes. If we call the 2000 Notes at a premium (in whole or in part), or if any of the holders of the 2000 Notes elected to convert the 2000 Notes (in whole or in part), we will be required to pay a variable rate and receive the fixed rate of 4.75% on the principal amount of such called or converted 2000 Notes.

Our interest rate swap qualifies under SFAS No. 133 as a fair-value hedge. We record the fair value of our interest rate swap and the change in the fair value of the underlying 2000 Notes attributable to changes in the LIBOR on our consolidated balance sheets, and we record the ineffectiveness arising from the difference between the two fair values in our consolidated statements of operations as “Other income (expense), net.” At December 31, 2003 and 2002, the fair value of the swap was approximately $11.6 million and $17.4 million, respectively, and the change in the fair value of our 2000 Notes attributable to changes in the LIBOR during the period resulted in an increase to the carrying value of our 2000 Notes of $11.2 million and $17.0 million, respectively. Unrealized gains on the interest rate swap were less than $0.1 million and $0.4 million for the years ended December 31, 2003 and 2002, respectively. At December 31, 2003 and 2002, our total restricted cash associated with the swap was $6.0 million.

F-37

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

We are exposed to credit exposure with respect to GSCM as counterparty under the swap. However, we believe that the risk of such credit exposure is limited because GSCM is an affiliate of a major U.S. investment bank and because its obligations under the swap are guaranteed by the Goldman Sachs Group L.P.

For the year ended December 31, 2003, we recorded interest expense of $5.3 million and interest income of $14.3 million, respectively, as a result of our interest rate swap. For the year ended December 31, 2002, we recorded interest expense of $7.9 million and interest income of $14.5 million, respectively, as a result of our interest rate swap and our prior interest rate swaps for the 2002 period. Our net interest expense, including the interest paid on our 2000 Notes, was $5.3 million, $8.9 million, and $23.6 million for the years ended December 31, 2003, 2002, and 2001, respectively.

NOTE 13—RESTRUCTURING, INTEGRATION AND OTHER RELATED CHARGES

We did not record any restructuring charges during the year ended December 31, 2003. See Note 5 for integration and other related charges we recorded during the year ended December 31, 2003.

During the second quarter of 2001, in conjunction with the acquisition of Freshwater, we recorded a charge for certain nonrecurring restructuring and integration costs of $0.9 million not considered part of the purchase price. The charge included costs for consolidation of facilities, employee severance, and fixed asset write-offs. As of June 30, 2002, all costs associated with the charge had been paid.

During the third quarter of 2001, in connection with management’s plan to reduce costs and improve operating efficiencies, we recorded restructuring and other charges of $4.4 million, consisting of $2.9 million for employee reductions, $1.1 million for the cancellation of a marketing event, and $0.4 million for professional services and consolidation of facilities. Employee reductions consisted of approximately 140 employees, or 8% of our worldwide workforce. All cash payments associated with the restructuring of $3.7 million was paid in full as of March 31, 2002. During the first quarter of 2002, we reversed $0.5 million of the cash restructuring charges associated with the cancellation of the marketing event because we were able to use the deposit for another event. The remaining restructuring costs of $0.2 million consisted of non-cash charges for asset write-offs.

F-38

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 14—SUPPLEMENTAL CASH FLOW DISCLOSURES

Supplemental cash flow disclosures for the years ended December 31, 2003, 2002, and 2001 are as follows (in thousands):

	Year ended December 31,
	2003			2002		2001
Supplemental disclosure:
Cash paid during the year for income taxes, net of refunds of $882 and $301, respectively	$	6,546		$	4,200	$	1,605
Cash paid during the year for interest expense	$	7,755		$	20,862	$	23,618
Supplemental non-cash investing activities:
Net assets (liabilities) acquired (assumed) in conjunction with acquisitions	$	(1,641	)	$	—	$	2,383
Issuance of common stock and stock options in conjunction with acquisitions	$	128,473		$	—	$	850
Tax effect of acquired intangible assets and tax benefits from acquisitions	$	3,306		$	—	$	3,002
Purchase of domain name in exchange for customer support service, and sales and technical training	$	491		$	—	$	—
Supplemental non-cash financing activities:
Tax benefit from exercise of stock options	$	6,367		$	—	$	6,118
Issuance of common stock for notes receivable	$	—		$	769	$	4,036
Elimination of debt offering costs in conjunction with debt retirement	$	—		$	1,229	$	2,663

NOTE 15—RELATED PARTIES

Notes receivable from issuance of common stock

At December 31, 2002, we held full-recourse notes receivable collateralized by common stock from our officers totaling $2.9 million for purchases of our common stock. The notes bear interest at the market rate on the date of issuance specific to the officer. Accrued interest was due quarterly. The principal amount was due between five to eight years from the anniversary of the notes. In March 31, 2003, our Chief Executive Officer repaid his notes in full prior to the due date in the aggregate amount of $3.4 million, of which $2.0 million related to notes receivable from issuance of common stock and $1.4 million related to officer receivables. As of December 31, 2003, there were no full-recourse notes receivable from officers outstanding.

In addition, at December 31, 2003 and 2002, we held full-recourse notes receivable collateralized by common stock from our employees totaling $6.6 million and $8.2 million, respectively, for purchases of our common stock. The notes bear interest at the market rate on the date of issuance specific to the employee. Accrued interest is due between one and five years from the date of issuance. The principal amount is due ten years from the anniversary of the notes or as common stock is sold.

F-39

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Employee and officer receivables

At December 31, 2003 and 2002, we held full-recourse notes receivable collateralized by our common stock and/or real property with an employee and an officer totaling $0.2 million and $1.6 million, respectively. The notes bear interest at the market rate on the date of issuance specific to the employee. Accrued interest is due either quarterly or annually. The principal amount is due between five and seven years from the anniversary of the notes.

Business with Wells Fargo & Company

Sale of products and services

We sell products and services to Wells Fargo & Company (Wells Fargo), a financial company, as part of the normal course of business. One of the members of our Board is an executive officer of Wells Fargo. We recorded total revenues from the sale of products and services to Wells Fargo of $2.1 million, $1.1 million, and $0.9 million for the years ended December 31, 2003, 2002, and 2001, respectively. Accounts receivable due from Wells Fargo was $1.3 million and $0.2 million as of December 31, 2003 and 2002, respectively.

Banking services

In addition, we obtain banking services from Wells Fargo. During 2003, we entered into four irrevocable letter of credit agreements totaling $1.4 million with Wells Fargo. The letters of credit are related to facility lease agreements assumed by us in conjunction with the acquisitions of Kintana and Freshwater and the facility lease agreement for our new headquarters in Mountain View, California. Two of the agreements have automatic annual renewal provisions under which the expiration dates cannot be extended beyond March 1, 2006 and August 31, 2006. The agreement for the facility lease of our new headquarters automatically renews annually after January 1, 2005 unless we provide a termination notice to Wells Fargo. The fourth agreement expires in September 2004. As of December 31, 2003, no letters of credit were drawn. During 2003 and 2002, we maintained cash deposit accounts and an investment account related to investments in our Israeli research and development facility with Wells Fargo. As of December 31, 2003 and 2002, total cash deposit balance was $6.3 million and $14.3 million, respectively. As of December 31, 2003 and 2002, the investment account balance was $163.8 million and $188.0 million, respectively.

Marketing agreement with Biz360

In January 2003, our Audit Committee approved a 15-month subscription agreement with Biz360, as one of our members of the Board of Directors serves on the Biz360 board of directors, to purchase marketing services for $110,000. In April 2003, we signed an extension to the subscription agreement with Biz360. In accordance with the extension to the agreement, Biz360 will provide additional marketing service to our European operations for $60,000 over a 15-month period. As of December 31, 2003, we have made $170,000 in payments toward this agreement.

Subcontractor arrangement with InteQ Corporation

In April 2001 and July 2002, we invested $3.0 million and $369,000 in InteQ Corporation (InteQ) for 6,782,727 shares and 834,512 shares of its Series B Preferred stock, respectively. These investments are accounted for using the cost method. We do not have a seat on the InteQ board of directors. In June 2002, we entered into a subcontractor agreement with InteQ to outsource the delivery of the monitoring and problem remediation solutions of our Global SiteReliance (GSR) service. The contract was scheduled to end in April 2003 and was extended to June 2003. Prior to the subcontractor agreement, we delivered the GSR service to three customers, which as of June 2002 have been transitioned to InteQ. For a subcontractor fee, InteQ would perform

F-40

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

the remaining services for these customers and any additional or new service contracts entered into by us. GSR service revenue of $151,000 and $261,000 related to these customers was netted against the subcontractor fee of $151,000 and $261,000 for the years ended December 31, 2003 and 2002, respectively. To perform the GSR service to our existing customers, InteQ has purchased a SiteScope thirteen-month term license from us for approximately $216,000. This term license was sold to InteQ with extended payment terms; consequently we are recognizing the revenue associated with this term license as payments are made by InteQ. To service additional customers, InteQ will have to acquire additional SiteScope licenses based upon certain criteria. During 2003, InteQ purchased additional SiteScope licenses aggregating $75,000, primarily for an existing customer. For the years ended December 31, 2003 and 2002, revenue of $199,000 and $73,000 was recorded for the InteQ SiteScope license, respectively.

In August 2002, we entered into a referral fee agreement whereby InteQ will pay us a 15% referral fee for customers referred by us to InteQ. The referral fee agreement ended on June 30, 2003. For the year ended December 31, 2003, we recorded $151,000 referral fee revenue from InteQ. No referral fee revenue was recognized during the year ended December 31, 2002.

NOTE 16—SEGMENT AND GEOGRAPHIC REPORTING

We have four reportable operating segments: the Americas, EMEA, APAC, and Japan. These segments are organized, managed, and analyzed geographically and operate in one industry segment: the development, marketing, and selling of integrated application delivery, application management, and IT governance solutions. Our chief decision makers evaluate operating segment performance based primarily on net revenues and certain operating expenses.

Net revenues for our operating segments were as follows (in thousands):

	Year ended December 31,
	2003		2002		2001
Net revenues to third parties:
Americas (including U.S. of $310,967, $251,222, and $168,003, respectively)	$	321,942	$	262,537	$	233,900
EMEA (including UK of $58,387, $40,776 and $41,866, respectively)		149,176		111,980		104,684
APAC		23,851		14,794		14,461
Japan		11,504		10,811		7,955
	$	506,473	$	400,122	$	361,000

Long-lived assets, which consist primarily of property and equipment, for our operating segments were as follows (in thousands):

	December 31,
	2003		2002
Property and equipment, net:
Americas (including U.S. of $40,750 and $54,469, respectively)	$	40,801	$	54,553
EMEA (including Israel of $28,288 and $29,280, respectively)		31,001		32,367
APAC		1,011		1,170
Japan		390		426
	$	73,203	$	88,516

F-41

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

International sales represented 36%, 34%, and 35% of our total revenues in 2003, 2002, and 2001, respectively. The subsidiary located in the United Kingdom accounted for 12%, 10%, and 12% of the consolidated net revenues to unaffiliated customers for the years ended December 31, 2003, 2002, and 2001, respectively. Operations located in Israel accounted for 19% and 27% of the consolidated identifiable assets at December 31, 2003 and 2002, respectively.

Although we operate in one industry segment, our chief decision makers evaluate net revenues based on the components of application delivery, application management, and IT governance. With the acquisition of Kintana in August 2003, we began recognizing revenue from sales of IT governance products. Accordingly, the following tables present revenues for application delivery, application management, and IT governance for the years ended December 31, 2003, 2002, and 2001 (in thousands):

	For the year ended December 31, 2003
	Application Delivery		Application Management		IT Governance		Total
Total revenues:
License fees	$	181,415	$	11,988	$	7,644	$	201,047
Subscription fees		43,495		55,334		29		98,858
Product revenue		224,910		67,322		7,673		299,905
Maintenance fees		149,769		7,601		1,660		159,030
Service fees		36,814		4,160		6,564		47,538
	$	411,493	$	79,083	$	15,897	$	506,473

	For the year ended December 31, 2002
	Application Delivery		Application Management		IT Governance		Total
Total revenues:
License fees	$	182,927	$	9,285	$	—	$	192,212
Subscription fees		20,623		32,401		—		53,024
Product revenue		203,550		41,686		—		245,236
Maintenance fees		116,939		5,404		—		122,343
Service fees		31,317		1,226		—		32,543
	$	351,806	$	48,316	$	—	$	400,122

	For the year ended December 31, 2001
	Application Delivery		Application Management		IT Governance		Total
Total revenues:
License fees	$	197,004	$	6,813	$	—	$	203,817
Subscription fees		12,194		20,589		—		32,783
Product revenue		209,198		27,402		—		236,600
Maintenance fees		96,790		1,746		—		98,536
Service fees		25,851		13		—		25,864
	$	331,839	$	29,161	$	—	$	361,000

F-42

MERCURY INTERACTIVE CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 17—SUBSEQUENT EVENTS

Sale of vacant buildings

On January 30, 2004, we sold the two vacant buildings in Sunnyvale, California at the carrying value to a third party for $2.7 million in cash.

Amendment to royalty agreement

In February 2004, we entered into an amendment extending the Motive technology license agreement to December 31, 2006. In accordance with the addendum, we will pay an additional $0.4 million to Motive for an additional 12-month maintenance and support service for the year ending December 31, 2006. The fee is due on December 31, 2005. In addition, the addendum accelerates the payment of the remaining royalty balance of $7.0 million, which was paid in February 2004.

F-43

UNAUDITED QUARTERLY FINANCIAL DATA

The following table sets forth selected unaudited consolidated quarterly financial information for the eight quarters ended December 31, 2003:

	Quarter ended
	Dec. 31, 2003		Sept. 30, 2003			June 30, 2003		March 31, 2003		Dec. 31, 2002		Sept. 30, 2002		June 30, 2002		March 31, 2002
	(in thousands, except per share amounts)
Total revenues	$	151,976	$	126,056		$	118,056	$	110,385	$	117,770	$	97,852	$	94,000	$	90,500
Net income (loss)	$	13,098	$	(6,664	)*	$	16,935	$	18,144	$	18,753	$	13,271	$	18,020	$	15,160
Basic net income (loss) per share	$	0.15	$	(0.08	)	$	0.20	$	0.21	$	0.22	$	0.16	$	0.21	$	0.18
Diluted net income (loss) per share	$	0.14	$	(0.08	)	$	0.19	$	0.20	$	0.21	$	0.15	$	0.20	$	0.17
Weighted average common shares (basic)		90,077		87,705			85,610		85,032		84,545		84,187		83,817		83,223
Weighted average common shares (diluted)		97,030		87,705			90,506		89,349		87,707		87,076		88,164		88,296

* Included a non-recurring charge of $10.7 million related to in-process research and development acquired from Kintana acquisition.

F-44

EX-3.3

Exhibit 3.3

AMENDED AND RESTATED

BY-LAWS

OF

MERCURY INTERACTIVE CORPORATION

ARTICLE I

CORPORATE OFFICES

1.1 REGISTERED OFFICE

The registered office of the corporation in the State of Delaware shall be 1209 Orange Street, Wilmington, County of New Castle, Delaware, 19801. The name of the registered agent of the corporation at such location is The Corporation Trust Company.

1.2 OTHER OFFICES

The board of directors may at any time establish other offices at any place or places where the corporation is qualified to do business.

1.3 BOOKS

The books of the corporation may be kept within or without the State of Delaware as the board of directors may from time to time determine or the business of the corporation may require.

ARTICLE II

MEETINGS OF STOCKHOLDERS

2.1 PLACE OF MEETINGS

Meetings of stockholders shall be held at such place, either within or without the State of Delaware on such date and at such time as may be determined from time to time by the board of directors (or the chairman in the absence of a designation by the board of directors) in its sole discretion. In the absence of any such designation, stockholders’ meetings shall be held at the registered office of the corporation.

2.2 ANNUAL MEETING

The annual meeting of stockholders shall be held each year on a date and at a time designated by the board of directors. At the meeting, directors shall be elected and any other proper business may be transacted.

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2.3 SPECIAL MEETING

A special meeting of the stockholders may be called at any time by the board of directors, or by the chairman of the board, or by the president. No other person or persons are permitted to call a special meeting. No business may be conducted at a special meeting other than the business brought before the meeting by the board of directors or the chairman of the board or the president.

2.4 NOTICE OF STOCKHOLDERS’ MEETINGS

All notices of meetings with stockholders shall be in writing and shall be sent or otherwise given in accordance with Section 2.5 of these by-laws not less than ten (10) nor more than sixty (60) days before the date of the meeting to each stockholder of record entitled to vote at such meeting. The notice shall specify the place, date, and hour of the meeting, and, in the case of a special meeting, the purpose or purposes for which the meeting is called.

2.5 MANNER OF GIVING NOTICE; AFFIDAVIT OF NOTICE

(a) Without limiting the manner by which notice otherwise may be given effectively to stockholders, written notice of any meeting of stockholders, if mailed, is given when deposited in the United States mail, postage prepaid, directed to the stockholder at such stockholder’s address as it appears on the records of the corporation.

(b) Without limiting the manner by which notice otherwise may be given effectively to stockholders, any notice to stockholders given by the corporation under any provision of the General Corporation Law of Delaware, the certificate of incorporation, or these by-laws shall be effective if given by a form of electronic transmission consented to by the stockholder to whom the notice is given. Any such consent shall be revocable by the stockholder by written notice to the corporation. Any such consent shall be deemed revoked if (1) the corporation is unable to deliver by electronic transmission 2 consecutive notices given by the corporation in accordance with such consent and (2) such inability becomes known to the secretary or an assistant secretary of the corporation or to the transfer agent, or other person responsible for the giving of notice; provided, however, the inadvertent failure to treat such inability as a revocation shall not invalidate any meeting or other action. Notice given pursuant to Section 2.5(b) shall be deemed given: (1) if by facsimile telecommunication, when directed to a number at which the stockholder has consented to receive notice; (2) if by electronic mail, when directed to an electronic mail address at which the stockholder has consented to receive notice; (3) if by a posting on an electronic network together with separate notice to the stockholder of such specific posting, upon the later of (A) such posting and (B) the giving of such separate notice; and (4) if by any other form of electronic transmission, when directed to the stockholder.

(c) An affidavit of the Secretary or an Assistant Secretary or of the transfer agent of the corporation that the notice has been given shall, in the absence of fraud, be prima facie evidence of the facts stated therein.

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2.6 QUORUM

The holders of a majority of the stock issued and outstanding and entitled to vote thereat, present in person or represented by proxy, shall constitute a quorum at all meetings of the stockholders for the transaction of business except as otherwise provided by statute or by the certificate of incorporation. If, however, such quorum is not present or represented at any meeting of the stockholders, then either (i) the Chairman of the meeting or (ii) the stockholders entitled to vote thereat, present in person or represented by proxy, shall have power to adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum is present or represented. At such adjourned meeting at which a quorum is present or represented, any business may be transacted that might have been transacted at the meeting as originally noticed.

2.7 ADJOURNED MEETING; NOTICE

When a meeting is adjourned to another time or place (whether or not a quorum is present), unless these by-laws otherwise require, notice need not be given of the adjourned meeting if the time and place thereof are announced at the meeting at which the adjournment is taken. At the adjourned meeting the corporation may transact any business that might have been transacted at the original meeting. If the adjournment is for more than thirty (30) days, or if after the adjournment a new record date is fixed for the adjourned meeting, a notice of the adjourned meeting shall be given to each stockholder of record entitled to vote at the meeting.

2.8 CONDUCT OF BUSINESS

The chairman of any meeting of stockholders shall determine the order of business and the procedure at the meeting, including such regulation of the manner of voting and the conduct of business.

2.9 VOTING

The stockholders entitled to vote at any meeting of stockholders shall be determined in accordance with the provisions of Section 2.12 of these by-laws, subject to the provisions of Sections 217 and 218 of the General Corporation Law of Delaware (relating to voting rights of fiduciaries, pledgors and joint owners of stock and to voting trusts and other voting agreements).

Except as may be otherwise provided in the certificate of incorporation, each stockholder shall be entitled to one vote for each share of capital stock held by such stockholder.

2.10 WAIVER OF NOTICE

Whenever notice is required to be given under any provision of the General Corporation Law of Delaware or of the certificate of incorporation or these by-laws, a written waiver thereof, signed by the person entitled to notice, or a waiver by electronic transmission by the person entitled to notice, whether before or after the time stated therein, shall be deemed equivalent to notice. Attendance of a person at a meeting shall constitute a waiver of notice of such meeting, except when the person attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or

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convened. Neither the business to be transacted at, nor the purpose of, any regular or special meeting of the stockholders need be specified in any written waiver of notice or any waiver by electronic transmission unless so required by the certificate of incorporation or these by-laws.

2.11 STOCKHOLDER ACTION BY WRITTEN CONSENT WITHOUT A MEETING

(a) Unless otherwise provided in the certificate of incorporation, any action required to be taken at any annual or special meeting of stockholders, or any action which may be taken at any annual or special meeting of stockholders, may be taken without a meeting, without prior notice and without a vote, if a consent or consents in writing, setting forth the action so taken, shall be signed by the holders of outstanding capital stock having not less than the minimum number of votes that would be necessary to authorize or take such action at a meeting at which all shares entitled to vote thereon were present and voted and shall be delivered to the corporation by delivery to its registered office in Delaware, its principal place of business, or an officer or agent of the Corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Delivery made to the corporation’s registered office shall be by hand or by certified or registered mail, return receipt requested. Prompt notice of the taking of the corporate action without a meeting by less than unanimous written consent shall be given to those stockholders who have not consented in writing and who, if the action had been taken at a meeting, would have been entitled to notice of the meeting if the record date for such meeting had been the date that written consents signed by a sufficient number of stockholders to take the action were delivered to the corporation as provided in Section 2.11(b).

(b) Every written consent shall bear the date of signature of each stockholder who signs the consent, and no written consent shall be effective to take the corporate action referred to therein unless, within sixty (60) days of the earliest dated consent delivered in the manner required by this section and Delaware Law to the Corporation, written consents signed by a sufficient number of holders to take action are delivered to the corporation by delivery to its registered office in Delaware, its principal place of business, or an officer or agent of the corporation having custody of the book in which proceedings of meetings of stockholders are recorded. Delivery made to the corporation’s registered office shall be by hand or by certified or registered mail, return receipt requested.

2.12 RECORD DATE FOR STOCKHOLDER NOTICE; VOTING; GIVING CONSENTS

In order that the corporation may determine the stockholders entitled to notice of or to vote at any meeting of stockholders or any adjournment thereof, or entitled to express consent to corporate action in writing without a meeting, or entitled to receive payment of any dividend or other distribution or allotment of any rights, or entitled to exercise any rights in respect of any change, conversion or exchange of stock or for the purpose of any other lawful action, the board of directors may fix, in advance, a record date, which shall not be more than sixty (60) nor less than ten (10) days before the date of such meeting, nor more than sixty (60) days prior to any other action.

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If the board of directors does not so fix a record date:

(i) The record date for determining stockholders entitled to notice of or to vote at a meeting of stockholders shall be at the close of business on the day next preceding the day on which notice is given, or, if notice is waived, at the close of business on the day next preceding the day on which the meeting is held.

(ii) The record date for determining stockholders entitled to express consent to corporate action in writing without a meeting, when no prior action by the board of directors is necessary, shall be the day on which the first written consent is expressed.

(iii) The record date for determining stockholders for any other purpose shall be at the close of business on the day on which the board of directors adopts the resolution relating thereto.

A determination of stockholders of record entitled to notice of or to vote at a meeting of stockholders shall apply to any adjournment of the meeting; provided, however, that the board of directors may fix a new record date for the adjourned meeting.

2.13 PROXIES

Each stockholder entitled to vote at a meeting of stockholders or to express consent or dissent to corporate action in writing without a meeting may authorize another person or persons to act for such stockholder by a written proxy, signed by the stockholder and filed with the secretary of the corporation, but no such proxy shall be voted or acted upon after three (3) years from its date, unless the proxy provides for a longer period. A proxy shall be deemed signed if the stockholder’s name is placed on the proxy (whether by manual signature, typewriting, telegraphic transmission or otherwise) by the stockholder or the stockholder’s attorney-in-fact. The revocability of a proxy that states on its face that it is irrevocable shall be governed by the provisions of Section 212(e) of the General Corporation Law of Delaware.

2.14 LIST OF STOCKHOLDERS ENTITLED TO VOTE

The officer who has charge of the stock ledger of a corporation shall prepare and make, at least 10 days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting, arranged in alphabetical order, and showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder for any purpose germane to the meeting for a period of at least ten (10) days prior to the meeting: (i) on a reasonably accessible electronic network, provided that the information required to gain access to such list is provided with the notice of the meeting, or (ii) during ordinary business hours, at the principal place of business of the corporation. In the event that the corporation determines to make the list available on an electronic network, the corporation may take reasonable steps to ensure that such information is available only to stockholders of the corporation. The list shall also be produced and kept at the time and place of the meeting during the whole time thereof and may be inspected by any stockholder who is present. Such list shall presumptively determine the identity of the stockholders entitled to vote at the meeting and the number of shares held by each of them.

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2.15 ADVANCE NOTICE OF STOCKHOLDER NOMINEES

Nominations of persons for election to the board of directors of the corporation may be made at a meeting of stockholders by or at the discretion of the board of directors or by any stockholder of the corporation entitled to vote in the election of directors at the meeting who complies with the notice procedures set forth in this Section. Such nominations, other than those made by or at the direction of the board of directors, shall be made pursuant to timely notice in writing to the Secretary of the corporation. To be timely, a stockholder’s notice shall be delivered to or mailed and received at the principal executive offices of the corporation not less than twenty (20) days nor more than sixty (60) days prior to the meeting; provided, however, that in the event less than thirty (30) days notice or prior public disclosure of the date of the meeting is given or made to stockholders, notice by the stockholder to be timely must be so received not later than the close of business on the tenth day following the day on which such notice of the date of the meeting was mailed or such public disclosure was made. Such stockholder’s notice shall set forth (a) as to each person, if any, whom the stockholder proposes to nominate for election or re-election as a director: (i) the name, age, business address and residence address of such person, (ii) the principal occupation or employment of such person, (iii) the class and number of shares of the corporation which are beneficially owned by such person, (iv) any other information relating to such person that is required by law to be disclosed in solicitations of proxies that is required by law to be disclosed in solicitations of proxies for election of directors, and (v) such person’s written consent to being named as a nominee and to serving as ‘a director if elected; and (b) as to the stockholder giving the notice: (i) the name and address, as they appear on the corporation’s books, of such stockholder, and (ii) the class and number of shares of the corporation which are beneficially owned by such stockholder, and (iii) a description of all arrangements or understandings between such stockholder and each nominee and any other person or persons (naming such person or persons) relating to the nomination. At the request of the board of directors any person nominated by the Board for election as a director shall furnish to the secretary of the corporation that information required to be set forth in the stockholder’s notice of nomination which pertains to the nominee. No person shall be eligible for election as a director of the corporation unless nominated in accordance with the procedures set forth in this Section. The chairman of the meeting shall, if the facts warrant, determine and declare at the meeting that a nomination was not made in accordance with the procedures prescribed by these by-laws, and if he should so determine, he shall so declare at the meeting and the defective nomination shall be disregarded.

2.16 ADVANCE NOTICE OF STOCKHOLDER BUSINESS

At the annual meeting of the stockholders, only such business shall be conducted as shall have been properly brought before the meeting. To be properly brought before an annual meeting, business must be: (a) as specified in the notice of meeting (or any supplement thereto) given by or at the direction of the board of directors, (b) otherwise properly brought before the meeting by or at the direction of the board of directors, or (c) otherwise properly brought before the meeting by a stockholder. Business to be brought before an annual meeting by a stockholder shall not be considered properly brought if the stockholder has not given timely notice thereof in writing to the secretary of the corporation. To be timely, a stockholder’s notice must be delivered to or mailed and received at the principal executive offices of the corporation not less than twenty (20) nor more than sixty (60) days prior to the meeting; provided, however, that in

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the event that less than thirty (30) days notice or prior public disclosure of the date of the meeting is given or made to stockholders, notice by the stockholder to be timely must be so received not later than the close of business on the tenth day following the day on which such notice of the date of the annual meeting was mailed or such public disclosure was made. A stockholder’s notice to the secretary shall set forth as to each matter the stockholder proposes to bring before the annual meeting: (i) a brief description of the business desired to be brought before the annual meeting and the reasons for conducting such business at the annual meeting, (ii) the name and address of the stockholder proposing such business, (iii) the class and number of shares of the corporation, which are beneficially owned by the stockholder, (iv) any material interest of the stockholder in such business, and (v) any other information that is required by law to be provided by the stockholder in his capacity as a proponent of a stockholder proposal. Notwithstanding anything in these by-laws to the contrary, no business shall be conducted at any annual meeting except in accordance with the procedures set forth in this Section. The chairman of the annual meeting shall, if the facts warrant, determine and declare at the meeting that business was not properly brought before the meeting and in accordance with the provisions of this Section, and, if he should so determine, he shall so declare at the meeting that any such business not properly brought before the meeting shall not be transacted.

ARTICLE III

DIRECTORS

3.1 POWERS

Subject to the provisions of the General Corporation Law of Delaware and any limitations in the certificate of incorporation or these by-laws relating to action required to be approved by the stockholders or by the outstanding shares, the business and affairs of the corporation shall be managed and all corporate powers shall be exercised by or under the direction of the board of directors.

3.2 NUMBER OF DIRECTORS

The board of directors shall consist of six (6) persons until changed by a proper amendment of this Section 3.2.

No reduction of the authorized number of directors shall have the effect of removing any director before that director’s term of office expires.

3.3 ELECTION, QUALIFICATION AND TERM OF OFFICE OF DIRECTORS

Except as provided in Section 3.4 of these by-laws, directors shall be elected at each annual meeting of stockholders to hold office until the next annual meeting. Directors need not be stockholders unless so required by the certificate of incorporation or these by-laws, wherein other qualifications for directors may be prescribed. Each director, including a director elected to fill a vacancy, shall hold office until his or her successor is elected and qualified or until his or her earlier resignation or removal.

Elections of directors need not be by written ballot.

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3.4 RESIGNATION AND VACANCIES

Any director may resign at any time by giving notice in writing or by electronic transmission to the board of directors or to the Secretary of the Corporation. The resignation of any director shall take effect upon receipt of notice thereof or at such later time as shall be specified in such notice; and unless otherwise specified therein, the acceptance of such resignation shall not be necessary to make it effective. When one or more directors so resigns and the resignation is effective at a future date, a majority of the directors then in office, including those who have so resigned, shall have power to fill such vacancy or vacancies, the vote thereon to take effect when such resignation or resignations shall become effective, and each director so chosen shall hold office as provided in this section in the filling of other vacancies.

Unless otherwise provided in the certificate of incorporation or these by-laws:

(i) Vacancies and newly created directorships resulting from any increase in the authorized number of directors elected by all of the stockholders having the right to vote as a single class may be filled by a majority of the directors then in office, although less than a quorum, or by a sole remaining director.

(ii) Whenever the holders of any class or classes of stock or series thereof are entitled to elect one or more directors by the provisions of the certificate of incorporation, vacancies and newly created directorships of such class or classes or series may be filled by a majority of the directors elected by such class or classes or series thereof then in office, or by a sole remaining director so elected.

If at any time, by reason of death or resignation or other cause, the corporation should have no directors in office, then any officer or any stockholder or an executor, administrator, trustee or guardian of a stockholder, or other fiduciary entrusted with like responsibility for the person or estate of a stockholder, may call a special meeting of stockholders in accordance with the provisions of the certificate of incorporation or these by-laws, or may apply to the Court of Chancery for a decree summarily ordering an election as provided in Section 211 of the General Corporation Law of Delaware.

If, at the time of filling any vacancy or any newly created directorship, the directors then in office constitute less than a majority of the whole board (as constituted immediately prior to any such increase), then the Court of Chancery may, upon application of any stockholder or stockholders holding at least ten (10) percent of the total number of the shares at the time outstanding having the right to vote for such directors, summarily order an election to be held to fill any such vacancies or newly created directorships, or to replace the directors chosen by the directors then in office as aforesaid, which election shall be governed by the provisions of Section 211 of the General Corporation Law of Delaware as far as applicable.

3.5 PLACE OF MEETINGS; MEETINGS BY TELEPHONE

The board of directors of the corporation may hold meetings, both regular and special, either within or outside the State of Delaware.

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Unless otherwise restricted by the certificate of incorporation or these by-laws, members of the board of directors, or any committee designated by the board of directors, may participate in a meeting of the board of directors, or any committee, by means of conference telephone or similar communications equipment by means of which all persons participating in the meeting can hear each other, and such participation in a meeting shall constitute presence in person at the meeting.

3.6 REGULAR MEETINGS

Regular meetings of the board of directors may be held without notice at such time and at such place as shall from time to time be determined by the board.

3.7 SPECIAL MEETINGS; NOTICE

Special meetings of the board of directors for any purpose or purposes may be called at any time by the chairman of the board, the president, any vice president, the secretary or any two (2) directors.

Notice of the time and place of special meetings shall be delivered personally or by telephone to each director or sent by first-class mail or telegram, charges prepaid, addressed to each director at that director’s address as it is shown on the records of the corporation. If the notice is mailed, it shall be deposited in the United States mail at least four (4) days before the time of the holding of the meeting. If the notice is delivered personally or by telephone or by telegram, it shall be delivered personally or by telephone or to the telegraph company at least forty-eight (48) hours before the time of the holding of the meeting. Any oral notice given personally or by telephone may be communicated either to the director or to a person at the office of the director who the person giving the notice has reason to believe will promptly communicate it to the director. The notice need not specify the purpose or the place of the meeting, if the meeting is to be held at the principal executive office of the corporation.

3.8 QUORUM

At all meetings of the board of directors, a majority of the authorized number of directors shall constitute a quorum for the transaction of business and the act of a majority of the directors present at any meeting at which there is a quorum shall be the act of the board of directors, except as may be otherwise specifically provided by statute or by the certificate of incorporation. If a quorum is not present at any meeting of the board of directors, then the directors present thereat may adjourn the meeting from time to time, without notice other than announcement at the meeting, until a quorum is present.

A meeting at which a quorum is initially present may continue to transact business notwithstanding the withdrawal of directors, if any action taken is approved by at least a majority of the required quorum for that meeting.

3.9 WAIVER OF NOTICE

Whenever notice is required to be given under any provision of the General Corporation Law of Delaware or of the certificate of incorporation or these by-laws, a written waiver thereof,

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signed by the person entitled to notice, or waiver by electronic transmission by such person, whether before or after the time stated therein, shall be deemed equivalent to notice. Attendance of a person at a meeting shall constitute a waiver of notice of such meeting, except when the person attends a meeting for the express purpose of objecting, at the beginning of the meeting, to the transaction of any business because the meeting is not lawfully called or convened. Neither the business to be transacted at, nor the purpose of, any regular or special meeting of the directors, or members of a committee of directors, need be specified in any written waiver of notice, or waiver by electronic transmission, unless so required by the certificate of incorporation or these by-laws.

3.10 BOARD ACTION BY WRITTEN CONSENT WITHOUT A MEETING

Unless otherwise restricted by the certificate of incorporation or these by-laws, any action required or permitted to be taken at any meeting of the board of directors or of any committee thereof may be taken without a meeting, if all members of the board or committee, as the case may be, consent thereto in writing or by electronic transmission, and the writing or writings or electronic transmission or transmissions, are filed with the minutes of proceedings of the Board or committee. Such filing shall be in paper form if the minutes are maintained in paper form and shall be in electronic form if the minutes are maintained in electronic form.

3.11 FEES AND COMPENSATION OF DIRECTORS

Unless otherwise restricted by the certificate of incorporation or these by-laws, the independent members of the board of directors, or a committee of the board of directors composed solely of independent directors, shall have the authority to fix the compensation of directors, including fees and expenses.

3.12 APPROVAL OF LOANS TO OFFICERS

The corporation may lend money to, or guarantee any obligation of, or otherwise assist any officer or other employee of the corporation or of its subsidiary, including any officer or employee who is a director of the corporation or its subsidiary, whenever, in the judgment of the directors, such loan, guaranty or assistance may reasonably be expected to benefit the corporation. The loan, guaranty or other assistance may be with or without interest and may be unsecured, or secured in such manner as the board of directors shall approve, including, without limitation, a pledge of shares of stock of the corporation. Nothing in this section contained shall be deemed to deny, limit or restrict the powers of guaranty or warranty of the corporation at common law or under any statute.

3.13 REMOVAL OF DIRECTORS

Unless otherwise restricted by statute, by the certificate of incorporation or by these by-laws, any director or the entire board of directors may be removed, with or without cause, by the holders of a majority of the shares then entitled to vote at an election of directors; provided, however, that, so long as stockholders of the corporation are entitled to cumulative voting, if less than the entire board is to be removed, no director may be removed without cause if the votes cast against his or her removal would be sufficient to elect such director if then cumulatively voted at an election of the entire board of directors.

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No reduction of the authorized number of directors shall have the effect of removing any director prior to the expiration of such director’s term of office.

ARTICLE IV

COMMITTEES

4.1 COMMITTEES OF DIRECTORS

The board of directors may, by resolution passed by a majority of the whole board, designate one or more committees, with each committee to consist of one or more of the directors of the corporation. The board may designate one or more directors as alternate members of any committee, who may replace any absent or disqualified member at any meeting of the committee. In the absence or disqualification of a member of a committee, the member or members thereof present at any meeting and not disqualified from voting, whether or not such member or members constitute a quorum, may unanimously appoint another member of the board of directors to act at the meeting in the place of any such absent or disqualified member. Any such committee, to the extent provided in the resolution of the board of directors or in the by-laws of the corporation, shall have and may exercise all the powers and authority of the board of directors in the management of the business and affairs of the corporation, and may authorize the seal of the corporation to be affixed to all papers that may require it; but no such committee shall have the power or authority to (i) amend the certificate of incorporation (except that a committee may, to the extent authorized in the resolution or resolutions providing for the issuance of shares of stock adopted by the board of directors as provided in Section 151(a) of the General Corporation Law of Delaware, fix the designations and any of the preferences or rights of such shares relating to dividends, redemption, dissolution, any distribution of assets of the corporation or the conversion into, or the exchange of such shares for, shares of any other class or classes or any other series of the same or any other class or classes of stock of the corporation or fix the number of shares of any series of stock or authorize the increase or decrease of the shares of any series), (ii) adopt an agreement of merger or consolidation under Sections 251 or 252 of the General Corporation Law of Delaware, (iii) recommend to the stockholders the sale, lease or exchange of all or substantially all of the corporation’s property and assets, (iv) recommend to the stockholders a dissolution of the corporation or a revocation of a dissolution, or (v) amend the by-laws of the corporation; and, unless the board resolution establishing the committee, the by-laws or the certificate of incorporation expressly so provide, no such committee shall have the power or authority to declare a dividend, to authorize the issuance of stock, or to adopt a certificate of ownership and merger pursuant to Section 253 of the General Corporation Law of Delaware.

4.2 COMMITTEE MINUTES

Each committee shall keep regular minutes of its meetings and report the same to the board of directors when required.

4.3 MEETINGS AND ACTION OF COMMITTEES

Meetings and actions of committees shall be governed by, and held and taken in accordance with, the provisions of Article III of these by-laws, Section 3.5 (place of meetings

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and meetings by telephone), Section 3.6 (regular meetings), Section 3.7 (special meetings and notice), Section 3.8 (quorum), Section 3.9 (waiver of notice), and Section 3.10 (action without a meeting), with such changes in the context of those by-laws as are necessary to substitute the committee and its members for the board of directors and its members; provided, however, that the time of regular meetings of committees may be determined either by resolution of the board of directors or by resolution of the committee, that special meetings of committees may also be called by resolution of the board of directors and that notice of special meetings of committees shall also be given to all alternate members, who shall have the right to attend all meetings of the committee. The board of directors may adopt rules for the government of any committee not inconsistent with the provisions of these by-laws.

ARTICLE V

OFFICERS

5.1 OFFICERS

The officers of the corporation shall be a president, a secretary, and a chief financial officer. The corporation may also have, at the discretion of the board of directors, a chairman of the board, one or more vice presidents, one or more assistant vice presidents, one or more assistant secretaries, one or more assistant treasurers, and any such other officers as may be appointed in accordance with the provisions of Section 5.3 of these by-laws. Any number of offices may be held by the same person.

5.2 APPOINTMENT OF OFFICERS

The officers of the corporation, except such officers as may be appointed in accordance with the provisions of Sections 5.3 or 5.5 of these by-laws, shall be appointed by the board of directors, subject to the rights, if any, of an officer under any contract of employment.

5.3 SUBORDINATE OFFICERS

The board of directors may appoint, or empower the president to appoint, such other officers and agents as the business of the corporation may require, each of whom shall hold office for such period, have such authority, and perform such duties as are provided in these by-laws or as the board of directors may from time to time determine.

5.4 REMOVAL AND RESIGNATION OF OFFICERS

Subject to the rights, if any, of an officer under any contract of employment, any officer may be removed, either with or without cause, by an affirmative vote of the majority of the board of: directors at any regular or special meeting of the board or, except in the case of an officer chosen by the board of directors, by any officer upon whom such power of removal may be conferred by the board of directors.

Any officer may resign at any time by giving written notice to the corporation. Any resignation shall take effect at the date of the receipt of that notice or at any later time specified in that notice; and, unless otherwise specified in that notice, the acceptance of the resignation

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shall not be necessary to make it effective. Any resignation is without prejudice to the rights, if any, of the corporation under any contract to which the officer is a party.

5.5 VACANCIES IN OFFICES

Any vacancy occurring in any office of the corporation shall be filled by the board of directors.

5.6 CHAIRMAN OF THE BOARD

The chairman of the board, if such an officer be elected, shall, if present, preside at meetings of the board of directors and exercise and perform such other powers and duties as may from time to time be assigned to him by the board of directors or as may be prescribed by these by-laws. If there is no president, then the chairman of the board shall also be the chief executive officer of the corporation and shall have the powers and duties prescribed in Section 5.7 of these by-laws.

5.7 PRESIDENT

Subject to such supervisory powers, if any, as may be given by the board of directors to the chairman of the board, if there be such an officer, the president shall be the chief executive officer of the corporation and shall, subject to the control of the board of directors, have general supervision, direction, and control of the business and the officers of the corporation. The president shall preside at all meetings of the stockholders and, in the absence or nonexistence of a chairman of the board, at all meetings of the board of directors. The president shall have the general powers and duties of management usually vested in the office of president of a corporation and shall have such other powers and duties as may be prescribed by the board of directors or these by-laws.

5.8 VICE PRESIDENTS

In the absence or disability of the president, the vice presidents, if any, in order of their rank as fixed by the board of directors or, if not ranked, a vice president designated by the board of directors, shall perform all the duties of the president and when so acting shall have all the powers of, and be subject to all the restrictions upon, the president. The vice presidents shall have such other powers and perform such other duties as from time to time may be prescribed for them respectively by the board of directors, these by-laws, the president or the chairman of the board.

5.9 SECRETARY

The secretary shall keep or cause to be kept, at the principal executive office of the corporation or such other place as the board of directors may direct, a book of minutes of all meetings and actions of directors, committees of directors, and stockholders. The minutes shall show the time and place of each meeting, whether regular or special (and, if special, how authorized and the notice given), the names of those present at directors’ meetings or committee meetings, the number of shares present: or represented at stockholders’ meetings, and the proceedings thereof.

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The secretary shall keep, or cause to be kept, at the principal executive office of the corporation or at the office of the corporation’s transfer agent or registrar, as determined by resolution of the board of directors, a share register, or a duplicate share register, showing the names of all stockholders and their addresses, the number and classes of shares held by each, the number and date of certificates evidencing such shares, and the number and date of cancellation of every certificate surrendered for cancellation.

The secretary shall give, or cause to be given, notice of all meetings of the stockholders and of the board of directors required to be given by law or by these by-laws. The secretary shall keep the seal of the corporation, if one be adopted, in safe custody and shall have such other powers and perform such other duties as may be prescribed by the board of directors or by these by-laws.

5.10 CHIEF FINANCIAL OFFICER

The chief financial officer shall keep and maintain, or cause to be kept and maintained, adequate and correct books and records of accounts of the properties and business transactions of the corporation, including accounts of its assets, liabilities, receipts, disbursements, gains, losses, capital retained earnings, and shares. The books of account shall at all reasonable times be open to inspection by any director.

The chief financial officer shall deposit all moneys and other valuables in the name and to the credit of the corporation with such depositories as may be designated by the board of directors. The chief financial officer shall disburse the funds of the corporation as may be ordered by the board of directors, shall render to the president and directors, whenever they request it, an account of all his or her transactions as chief financial officer and of the financial condition of the corporation, and shall have other powers and perform such other duties as may be prescribed by the board of directors or these by-laws.

The chief financial officer shall be the treasurer of the corporation.

5.11 ASSISTANT SECRETARY

The assistant secretary, or, if there is more than one, the assistant secretaries in the order determined by the stockholders or board of directors (or if there be no such determination, then in the order of their election) shall, in the absence of the secretary or in the event of his or her inability or refusal to act, perform the duties and exercise the powers of the secretary and shall perform such other duties and have such other powers as may be prescribed by the board of directors or these by-laws.

5.12 ASSISTANT TREASURER

The assistant treasurer, or, if there is more than one, the assistant treasurers, in the order determined by the stockholders or board of directors (or if there be no such determination, then in the order of their election), shall, in the absence of the chief financial officer or in the event of his or her inability or refusal to act, perform the duties and exercise the powers of the chief financial officer and shall perform such other duties and have such other powers as may be prescribed by the board of directors or these by-Laws.

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5.13 REPRESENTATION OF SHARES OF OTHER CORPORATIONS

The chairman of the board, the president, any vice president, the chief financial officer, the secretary or assistant secretary of this corporation, or any other person authorized by the board of directors or the president or a vice president, is authorized to vote, represent, and exercise on behalf of this corporation all rights incident to any and all shares of any other corporation or corporations standing in the name of this corporation. The authority granted herein may be exercised either by such person directly or by any other person authorized to do so by proxy or power of attorney duly executed by such person having the authority.

5.14 AUTHORITY AND DUTIES OF OFFICERS

In addition to the foregoing authority and duties, all officers of the corporation shall respectively have such authority and perform such duties in the management of the business of the corporation as may be designated from time to time by the board of directors or the stockholders.

ARTICLE VI

INDEMNITY

6.1 THIRD PARTY ACTIONS

The corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending, or completed action, suit or proceeding, whether civil, criminal, administrative or investigative (other than an action by or in the right of the corporation) by reason of the fact that he is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture trust or other enterprise, against expenses (including attorneys’ fees), judgments, fines and amounts paid in settlement (if such settlement is approved in advance by the corporation, which approval shall not be unreasonably withheld) actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. The termination of any action, suit or proceeding by judgment, order, settlement, conviction, or upon a plea of nolo contendere or its equivalent, shall not, of itself, create a presumption that the person did not act in good faith and in a manner which such person reasonably believed to be in or not opposed to the best interest of the corporation, and, with respect to any criminal action or proceeding, had reasonable cause to believe that his conduct was; unlawful.

6.2 ACTIONS BY OR IN THE RIGHT OF THE CORPORATION

The corporation shall indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor by reason of the fact that such person is or was a director, officer, employee or agent of corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise against, expenses (including attorneys’ fees) and amounts paid

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in settlement (if such settlement is approved in advance by the corporation, which approval shall not be unreasonably withheld) actually and reasonably incurred by such person in connection with the defense or settlement of such action or suit if the person acted in good faith and in manner the person reasonably believed to be in or not opposed to the best interests of the corporation, except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the Delaware Court of Chancery or the court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Delaware Court of Chancery or such other court shall deem proper. Notwithstanding any other provision of this Article VI, no person shall be indemnified hereunder for any expenses or amounts paid in settlement with respect to any action to recover short-swing profits under Section 16(b) of the Securities Exchange Act of 1934, as amended.

6.3 SUCCESSFUL DEFENSE

To the extent that a director, officer, employee or agent of the corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in Sections 6.1 and 6.2, or in defense of any claim, issue or matter therein, such person shall be indemnified against expenses (including attorneys’ fees) actually and reasonably incurred by the person in connection therewith.

6.4 DETERMINATION OF CONDUCT

Any indemnification under Sections 6.1 and 6.2 (unless ordered by a court) shall be made by the corporation only as authorized in the specific case upon a determination that the indemnification of the director, officer, employee or agent is proper in the circumstances because the person has met the applicable standard of conduct set forth in Sections 6.1 and 6.2. Such determination shall be made (1) by the Board of Directors or the Executive Committee by a majority vote of a quorum consisting of directors who were not parties to such action, suit or proceeding or (2) or if such quorum is not obtainable or, even if obtainable, a quorum of disinterested directors so directs, by independent legal counsel in a written opinion, or (3) by the stockholders. Notwithstanding the foregoing, a director, officer, employee or agent of the Corporation shall be entitled to contest any determination that the director, officer, employee or agent has not met the applicable standard of conduct set forth in Sections 6.1 and 6.2 by petitioning a court of competent jurisdiction.

6.5 PAYMENT OF EXPENSES IN ADVANCE

Expenses incurred in defending a civil or criminal action, suit or proceeding, by an individual who may be entitled to indemnification pursuant to Section 6.1 or 6.2, shall be paid by the corporation in advance of the final disposition of such action, suit or proceeding upon receipt of an undertaking by or on behalf of the director, officer, employee or agent to repay such amount if it shall ultimately be determined that the individual is not entitled to be indemnified by the corporation as authorized in this Article VI.

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6.6 INDEMNITY NOT EXCLUSIVE

The indemnification and advancement of expenses provided by or granted pursuant to the other sections of this Article VI shall not be deemed exclusive of any other rights to which those seeking indemnification or advancement of expenses may be entitled under any by-law, agreement, vote of stockholders or disinterested directors or otherwise, both as to action in their official capacity and as to action in another capacity while holding such office.

6.7 INSURANCE INDEMNIFICATION

The corporation shall have the power to purchase and maintain insurance on behalf of any person who is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against any liability asserted against the person and incurred by the person in any such capacity or arising out of the person’s status as such, whether or not the corporation would have the power to indemnify such person against such liability under the provisions of this Article VI.

6.8 THE CORPORATION

For purposes of this Article VI, references to “the corporation” shall include, in addition to the resulting corporation, any constituent corporation (including any constituent of a constituent) absorbed in a consolidation or merger which, if its separate existence had continued, would have had power and authority to indemnify its directors, officers, and employees or agents, so that any person who is or was a director, officer, employee or agent of such constituent corporation, or is or was serving at the request of such constituent corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, shall stand in the same position under and subject to the provisions of this Article VI (including, without limitation the provisions of Section 6.4) with respect to the resulting or surviving corporation as the person would have with respect to such constituent corporation if its separate existence had continued.

6.9 EMPLOYEE BENEFIT PLANS

For purposes of this Article VI, references to “other enterprises” shall include employee benefit plans; references to “fines” shall include any excise taxes assessed on a person with respect to an employee benefit plan; and references to “serving at the request of the corporation” shall include any service as a director, officer, employee or agent of the corporation which imposes duties on, or involves services by, such director, officer, employee, or agent with respect to an employee benefit plan, its participants, or beneficiaries; and a person who acted in good faith and in a manner he reasonably believed to be in the interest of the participants and beneficiaries of an employee benefit plan shall be deemed to have acted in a manner “not opposed to the best interests of the corporation.” as referred to in this Article VI.

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6.10 CONTINUATION OF INDEMNIFICATION AND ADVANCEMENT OF EXPENSES

The indemnification and advancement of expenses provided by, or granted pursuant to, this Article VI shall, unless otherwise provided when authorized or ratified, continue as to a person who has ceased to be a director, officer, employee or agent and shall inure to the benefit of the heirs, executors and administrators of such a person.

ARTICLE VII

RECORDS AND REPORTS

7.1 MAINTENANCE AND INSPECTION OF RECORDS

The corporation shall, either at its principal executive officer or at such place or places as designated by the board of directors, keep a record of its stockholders listing their names and addresses and the number and class of shares held by each stockholder, a copy of these by-laws as amended to date, accounting books, and other records.

Any stockholder of record, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose the corporation’s stock ledger, a list of its stockholders, and its other books and records and to make copies or extracts therefrom. A proper purpose shall mean a purpose reasonably related to such person’s interest as a stockholder. In every instance where an attorney or other agent is the person who seeks the right to inspection, the demand under oath shall be accompanied by a power of attorney or such other writing that authorizes the attorney or other agent so to act on behalf of the stockholder. The demand under oath shall be directed to the corporation at its registered office in Delaware or at its principal place of business.

The officer who has charge of the stock ledger of the corporation shall prepare and make, at least ten (10) days before every meeting of stockholders, a complete list of the stockholders entitled to vote at the meeting, arranged in alphabetical order, showing the address of each stockholder and the number of shares registered in the name of each stockholder. Such list shall be open to the examination of any stockholder, for any purpose germane to the meeting, during ordinary business hours, for a period of at least ten (10) days prior to the meeting, either at a place within the city where the meeting is to be held, which place shall be specified in the notice of the meeting, or, if not so specified, at the place where the meeting is to be held. The list shall also be produced and kept at the time and place of the meeting during the whole time thereof, and may be inspected by any stockholder who is present.

7.2 INSPECTION BY DIRECTORS

Any director shall have the right to examine the corporation’s stock ledger, a list of its stockholders, and its other books and records for a purpose reasonably related to his position as a director. The Court of Chancery is hereby vested with the exclusive jurisdiction to determine whether a director is entitled to the inspection sought. The Court may summarily order the corporation to permit the director to inspect any and all books and records, the stock ledger, and the stock list and to make copies or extracts therefrom. The Court may, in its discretion,

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prescribe any limitations or conditions with reference to the inspection, or award such other and further relief as the Court may deem just and proper.

ARTICLE VIII

GENERAL MATTERS

8.1 CHECKS

From time to time, the board of directors shall determine by resolution which person or persons may sign or endorse all checks, drafts, other orders for payment of money, notes or other evidences of indebtedness that are issued in the name of or payable to the corporation, and only the persons so authorized shall sign or endorse those instruments.

8.2 EXECUTION OF CORPORATE CONTRACTS AND INSTRUMENTS

The board of directors, except as otherwise provided in these by-laws, may authorize any officer or officers, or agent or agents, to enter into any contract or execute any, instrument in the name of and on behalf of the corporation; such authority may be general or confined to specific instances. Unless so authorized or ratified by the board of directors or within the agency power of an officer, no officer, agent or employee shall have any power or authority to bind the corporation by any contract or engagement or to pledge its credit or to render it liable for any purpose or for any amount.

8.3 STOCK CERTIFICATES; PARTLY PAID SHARES

The shares of the corporation shall be represented by certificates, provided that the board of directors of the corporation may provide by resolution or resolutions that some or all of any or all classes or series of its stock shall be uncertificated shares. Any such resolution shall not apply to shares represented by a certificate until such certificate is surrendered to the corporation. Notwithstanding the adoption of such a resolution by the board of directors, every holder of stock represented by certificates and upon request every holder of uncertificated shares shall be entitled to have a certificate signed by, or in the name of the corporation by the chairman or vice-chairman of the board of directors, or the president or vice-president, and by the chief financial officer or an assistant treasurer, or the secretary or an assistant secretary of such corporation representing the number of shares registered in certificate form. Any or all of the signatures on the certificate may be a facsimile. In case, any officer, transfer agent or registrar who has signed or whose facsimile signature has been placed upon a certificate has ceased to be such officer, transfer agent or registrar before such certificate is issued, it may be issued by the corporation with the same effect as if the person were such officer, transfer agent or registrar at the date of issue.

The corporation may issue the whole or any part of its shares as partly paid and subject to call for the remainder of the consideration to be paid therefor. Upon the face or back of each stock certificate issued to represent any such partly paid shares, upon the books and records of the corporation in the case of uncertificated partly paid shares, the total amount of the consideration to be paid therefor and the amount paid thereon shall be stated. Upon the declaration or any dividend on fully paid shares, the corporation shall declare a dividend upon

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partly paid shares of the same class, but only upon the basis of the percentage of the consideration actually paid thereon.

8.4 SPECIAL DESIGNATION ON CERTIFICATES

If the corporation is authorized to issue more than one class of stock or more than one series of any class, then the powers, the designations, the preferences, and the relative, participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights shall be set forth in full or summarized on the face or back of the certificate that the corporation shall issue to represent such class or series of stock; provided, however, that, except as otherwise provided in Section 202 of the General Corporation Law of Delaware, in lieu of the foregoing requirements there may be set forth on the face or back of the certificate that the corporation shall issue to represent such class or series of stock a statement that the corporation will furnish without charge to each stockholder who so requests the powers, the designations, the preferences, and the relative, participating, optional or other special rights of each class of stock or series thereof and the qualifications, limitations or restrictions of such preferences and/or rights.

8.5 LOST CERTIFICATES

Except as provided in this Section 8.5, no new certificates for shares shall be issued to replace a previously issued certificate unless the latter is surrendered to the corporation and canceled at the same time. The corporation may issue a new certificate of stock or uncertificated shares in the place of any certificate theretofore issued by it, alleged to have been lost, stolen or destroyed, and the corporation may require the owner of the lost, stolen or destroyed certificate, or the owner’s legal representative, to give the corporation a bond sufficient to indemnify it against any claim that may be made against it on account of the alleged loss, theft or destruction of any such certificate or the issuance of such new certificate or uncertificated shares.

8.6 CONSTRUCTION; DEFINITIONS

Unless the context requires otherwise, the general provisions, rules of construction, and definitions in the General Corporation Law of Delaware shall govern the construction of these by-laws. Without limiting the generality of this provision, the singular number includes the plural, the plural number includes the singular, and the term “person” includes both a corporation and a natural person.

8.7 DIVIDENDS

The directors of the corporation, subject to any restrictions contained in (i) the General Corporation Law of Delaware or (ii) the certificate of incorporation, may declare and pay dividends upon the shares of capital stock of the corporation. Dividends may be paid in cash, in property, or in shares of the capital stock of the corporation.

The directors of the corporation may set apart out of any of the funds of the corporation available for dividends a reserve or reserves for any proper purpose and may abolish any such reserve. Such purposes shall include but not be limited to equalizing dividends, repairing or maintaining any property of the corporation, and meeting contingencies.

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8.8 FISCAL YEAR

The fiscal year of the corporation shall be fixed by resolution of the board of directors and may be changed by the board of directors.

8.9 SEAL

The corporation may adopt a corporate seal, which shall be adopted and which may be altered by the board of directors, and may use the same by causing it or a facsimile thereof to be impressed or affixed or in any other manner reproduced.

8.10 TRANSFER OF STOCK

Upon surrender to the corporation or the transfer agent of the corporation of a certificate for shares duly endorsed or accompanied by proper evidence of succession, assignation or authority to transfer, it shall be the duty of the corporation to issue a new certificate to the person entitled thereto, cancel the old certificate, and record the transaction in its books.

8.11 STOCK TRANSFER AGREEMENTS

The corporation shall have power to enter into and perform any agreement with any number of stockholders of any one or more classes of stock of the corporation to restrict the transfer of shares of stock of the corporation of any one or more classes owned by such stockholders in any manner not prohibited by the General Corporation Law of Delaware.

8.12 REGISTERED STOCKHOLDERS

The corporation shall be entitled to recognize the exclusive right of a person registered on its books as the owner of shares to receive dividends and to vote as such owner, shall be entitled to hold liable for calls and assessments the person registered on its books as the owner of shares, and shall not be bound to recognize any equitable or other claim to or interest in such share or shares on the part of another person, whether or not it shall have express or other notice thereof, except as otherwise provided by the laws of Delaware.

ARTICLE IX

AMENDMENTS

The by-laws of the corporation may be adopted, amended or repealed by the stockholders entitled to vote; provided, however, that the corporation may, in its certificate of incorporation, confer the power to adopt, amend or repeal by-laws upon the directors. The fact that such power has been so conferred upon the directors shall not divest the stockholders of the power, nor limit their power to adopt, amend or repeal by-laws.

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EX-10.19

EXHIBIT 10.19

LEASE AGREEMENT

by and between

369 Whisman Associates, L.P.,

a California limited partnership

(“Landlord”)

and

Mercury Interactive Corporation,

a Delaware corporation

(“Tenant”)

Dated as of December 15, 2003

1.	LEASED PREMISES.	5
2.	OCCUPANCY AND USE.	7
3.	TERM AND POSSESSION.	7
4.	RENT; RENT ADJUSTMENTS; ADDITIONAL CHARGES FOR EXPENSES AND TAXES.	8
5.	MANAGEMENT.	13
6.	RESTRICTIONS ON USE.	14
7.	COMPLIANCE WITH LAWS.	14
8.	ADDITIONAL ALTERATIONS.	15
9.	REPAIR AND MAINTENANCE.	17
10.	LIENS.	19
11.	ASSIGNMENT AND SUBLETTING.	20
12.	INSURANCE AND INDEMNIFICATION.	23
13.	WAIVER OF SUBROGATION.	25
14.	SERVICES AND UTILITIES.	25
15.	TENANT’S CERTIFICATES.	27
16.	HOLDING OVER.	27
17.	SUBORDINATION.	27
18.	RULES AND REGULATIONS.	28
19.	RE-ENTRY BY LANDLORD.	28
20.	INSOLVENCY OR BANKRUPTCY.	28
21.	DEFAULT.	29
22.	DAMAGE AND DESTRUCTION.	30
23.	EMINENT DOMAIN.	32
24.	SALE BY LANDLORD.	33
25.	RIGHT OF LANDLORD TO PERFORM.	33
26.	EXISTING TENANT IMPROVEMENTS; OWNERSHIP OF IMPROVEMENTS; SURRENDER OF PREMISES.	34

27.	WAIVER.	35
28.	NOTICES.	35
29.	TAXES PAYABLE BY TENANT.	35
30.	ABANDONMENT.	35
31.	SUCCESSORS AND ASSIGNS.	36
32.	ATTORNEY’S FEES.	36
33.	LIGHT AND AIR.	36
34.	SECURITY FOR LEASE.	36
35.	FINANCIAL INFORMATION.	37
36.	PARKING.	38
37.	MISCELLANEOUS.	38
38.	REAL ESTATE BROKERS.	38
39.	HAZARDOUS MATERIALS LIABILITY.	38
40.	ARBITRATION OF DISPUTES.	40
41.	SIGNAGE.	42
42.	RIGHT OF FIRST NEGOTIATION.	42

BASIC LEASE INFORMATION

Lease Date:	December 15, 2003
LANDLORD:	369 Whisman Associates, L.P., a California Limited Partnership
Landlord’s Address:	700 Emerson Palo Alto, CA 94301
TENANT:	Mercury Interactive Corporation, a Delaware corporation
Tenant’s Address:	FOR NOTICE (PRIOR TO COMMENCEMENT): Mercury Interactive Corporation 1325 Borregas Drive Sunnyvale, California 94069 Attn: Vice President and General Counsel
	AFTER COMMENCEMENT DATE: To the Premises Attn: Vice President and General Counsel
Premises:	Four (4) separate, adjacent buildings (each, a “Building” and collectively, the “Buildings”), having addresses at 389 Whisman Road (“Building 4”), 399 Whisman Road (“Building 5”), 369 Whisman Road (“Building 6”), and 379 Whisman Road (“Building 7”), Mountain View, California, as shown on Exhibit “A” attached hereto.
Parcel 2:	The Buildings, land and improvements located in the area designated as “Parcel 2” on the parcel map attached hereto as Exhibit “B”, subject to Subparagraphs 1(c) and 1(d).
Project:	The Project consists of (i) Parcel 2; (ii) the buildings, land and improvements located in the area designated as “Parcel 1” on Exhibit “B” (such buildings, land and improvements being defined as “Parcel 1”); (iii) the land and the parking improvements and common area facilities currently located in the cross-hatched portion of the area designed as “Parcel 3” on Exhibit “B” (such improvements and land being defined as “Parcel 3”); (iv) the land and the parking improvements and common area facilities located on an easement over certain real property adjacent to Parcels 1, 2 and 3 from the City and County of San Francisco, acting by and through its Public Utilities Commission, San Francisco Water Department, located in the area designated as “City and County of San Francisco” on Exhibit “B” (the “Hetch Hetchy Easement”); and (v) any and all future improvements located on Parcel 1, Parcel 2, Parcel 3 or the Hetch Hetchy Easement. The Project as it exists as of the Effective Date is shown as the cross-hatched area on Exhibit “B”. The Project may be expanded to include other land and improvements, or reduced to eliminate portions of the existing Project, in accordance with Subparagraphs 1(b), (c) and (d).

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Rentable Area of the Premises:	Deemed to be 252,550 Rentable Square Feet (“Rentable Area”). Landlord and Tenant hereby stipulate and agree that this square footage shall be conclusive for all purposes under this Lease.
Tenant’s Use of the Premises:	Tenant shall use the Premises for office, distribution, research and development, and/or light manufacturing, and for customer training and sales presentations, and for no other purposes.
Lease Term:	Commencing on the Commencement Date and ending on the Expiration Date
Commencement Date:	See Paragraph 3
Rent Commencement Date:	July 1, 2004 (“Rent Commencement Date”).
Expiration Date:	February 20, 2014 (“Expiration Date”).
Rent:	Base Rent plus Additional Charges.
Monthly Base Rent:	As provided in Paragraph 4(b) (“Monthly Base Rent”).
Security Deposit:	Tenant shall provide and maintain a letter of credit in the initial amount of Eight Hundred Seventy-One Thousand Two Hundred Ninety-Seven and 50/100 Dollars ($871,297.50) as more specifically provided in Paragraph 34 [Security for Lease], which amount may be reduced during the Term in accordance with such paragraph.
Guarantor of Lease:	None
Brokers:	None

The foregoing Basic Lease Information is hereby incorporated into and made a part of this Lease. Each reference in this Lease to any of the Basic Lease Information shall mean the information hereinabove set forth and shall be construed to incorporate all of the terms provided under the particular paragraph pertaining to such information. In the event of any conflict between any Basic Lease Information and any other portion of the Lease, the latter shall control.

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LANDLORD:
369 Whisman Associates, L.P., a California limited partnership
By:	Cañada Corp.,
	a California corporation,
	Its General Partner
	By:	/s/    JOYCE YAMAGIWA
	Its:	Vice President
By:	Virginia Land Company, Inc.,
	a California corporation,
	Its General Partner
	By:	/s/    JOHN B. LOVEWELL
	Its:	Manager and President
TENANT:
Mercury Interactive Corporation, a Delaware corporation
By:	/s/    SUSAN J. SKAER
Its:	Vice President, General Counsel & Secretary

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LEASE AGREEMENT

THIS LEASE AGREEMENT (this “Lease”) is made and entered into as of December 15, 2003 (the “Effective Date”), by and between 369 Whisman Associates, L.P., a California limited partnership (herein called “Landlord”), and Mercury Interactive Corporation, a Delaware corporation (herein called “Tenant”).

RECITALS

A. Landlord, as successor-in-interest to 464 Ellis Street Associates, L.P., is the landlord and Netscape Communications Corporation, a Delaware corporation (“Netscape”) is the tenant under that certain Lease Agreement (Phase II) dated January 31, 1997 (the “Existing Lease”), for the Premises.

B. Pursuant to a Lease Termination Agreement (the “Termination Agreement”), Netscape and Landlord have agreed to accelerate the expiration of the term of the Existing Lease, and Netscape has agreed to surrender the Premises to Tenant on or before such expiration, all on the terms and conditions of the Termination Agreement. Immediately upon such expiration of the Term, Landlord intends to lease the Premises to Tenant, and Tenant intends to lease the Premises from Landlord, on the terms and conditions of this Lease.

C. In connection with this Lease, Netscape and Tenant intend to enter into (i) a Side Agreement (the “Side Agreement”) with respect to certain facilities operated by Netscape on Parcel 1, and pursuant to which Netscape will provide access to Tenant to install certain interior improvements to the Premises subject to the requirements of this Lease and the Existing Lease with respect to Alterations (such Alterations being defined as the “Initial Alterations”), and agree to cooperate with Tenant in connection with the installation of the Initial Alterations and provide and disburse the Allowance (as defined in the Side Agreement) (collectively, the “Early Access Provisions”), all on the terms and conditions of the Side Agreement. Tenant acknowledges and agrees that Landlord has no obligations under the Side Agreement or any other agreement, document or instrument by and between Netscape and Tenant with respect to the Premises and/or Project, and shall not be liable or responsible for any failure by Netscape to perform its obligations under the Side Agreement or any other agreement, document or instrument by and between Netscape and Tenant with respect to the Premises and/or Project, and that the rights and obligations of Landlord and Tenant under this Lease are not contingent in any way upon the existence of and/or performance by any party under the Side Agreement or any other agreement, document or instrument with respect to the Premises and/or Project, except as expressly provided in Section 3 below. Landlord has consented to the exercise by Tenant and Netscape of their respective rights and obligations as set forth in the Early Access Provisions pursuant to the terms of that certain Letter Agreement, dated November 10, 2003, by and between Landlord and Netscape.

1. LEASED PREMISES

(a) Premises. Upon and subject to the terms, covenants and conditions hereinafter set forth, Landlord agrees to lease to Tenant and Tenant agrees to hire from Landlord the Premises (as defined in the Basic Lease Information). The Premises are located within, and a part of, Parcel 2.

(b) Project; Common Areas; Access & Cooperation.

(i) Definition of Project. The term “Project” shall be as defined in the Basic Lease Information. Landlord shall have the right, at any time and from time to time, to expand the land and improvements which are included in the “Project” to include any future buildings and improvements located within Parcel 1, Parcel 2, Parcel 3, the Hetch Hetchy Easement, and/or any other property acquired by Landlord or its affiliates which is contiguous to the Project (as such term is defined at any given time), regardless of whether any such other property is leased to Tenant or leased to, sold to or occupied by a third party or third parties. Landlord may also, at any time and from time to time, eliminate all or

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portions of Parcel 1, Parcel 3 or the Hetch Hetchy Easement from the Project so long as such elimination does not materially adversely affect Tenant’s use of the Premises, the Minimum Parking or access to the Premises. Landlord shall deliver written notice to Tenant of Landlord’s intent to expand or reduce the Project, identifying the property and improvements which will be added to the Project.

(ii) Definition of Common Area. The term “Common Area” shall mean all areas and facilities within Parcel 2 located outside the perimeter footings of the Buildings and/or the perimeter footings of any future buildings constructed on Parcel 2, including the landscaped areas, service areas, parking areas, recreation areas, trash enclosures, plaza, walkways, driveways, sidewalks, access and perimeter roads, and the like; but excluding from the Common Area all monitoring wells, slurry walls, extraction wells, remediation equipment, piping, and other equipment (collectively, the “Clean-up Facilities”) which have been or may be installed on the Project for the purpose of conducting monitoring and remediation of Hazardous Materials. The Clean-up Facilities are or will be owned and controlled by Schlumberger Technology Corporation (“Seller”).

(iii) Use of Common Area. Tenant shall have the right to non-exclusive use of the Common Area and any other areas and facilities designated as common area and located in other portions of the Project, together with other tenants, occupants and owners of portions of the Project, subject to the terms of this Lease. The operation and use of the Common Area shall be governed by that certain Amended and Restated Declaration of Covenants, Conditions and Restrictions and Easement Agreement—The Quad, dated as of July 12, 2002 and recorded in the Official Records of the County of Santa Clara, State of California, as Document No. 16355625, a copy of which is attached hereto as Exhibit “C”, with such modifications as Landlord may reasonably determine to be appropriate (as they may be modified from time to time, the “CC&Rs”). The CC&Rs will at all times be superior in priority to this Lease. Landlord shall have the right to make reasonable modifications to the CC&Rs during the Term, including, without limitation, in order to provide necessary or appropriate access over, across and from the Common Area (including any roadways and drive aisles located thereon) to any property which is included in the Project; provided that such modifications do not materially adversely affect Tenant’s use of the Premises, Minimum Parking, or access to the Premises.

(iv) Landlord Access. Landlord shall have reasonable and appropriate access across the Common Area to other land which is included, or which Landlord intends to include, in the Project, at all reasonable times for purposes of construction and development of the Project. In connection with the development of other portions of the Project or of other improvements on Parcel 2, Tenant shall cooperate with Landlord in the establishment, execution and recordation of any conditions, covenants, restrictions, easements, licenses and/or other rights and interests which encumber Parcel 2 for the benefit of other portions of the Project, and which are required in order to provide sufficient parking for any portion of the Project or in connection with other development requirements for any portion of the Project, provided that such conditions, covenants, restrictions, easements, licenses, and/or other rights and interests do not materially adversely affect Tenant’s use of the Premises, Minimum Parking or access to the Premises and Tenant shall not be required to incur any out-of-pocket cost in connection with such cooperation. Tenant shall execute and deliver any documents or instruments reasonably required in connection therewith upon Landlord’s request.

(c) Reconfiguration of Parcel 2. Landlord reserves the right, without incurring any liability to Tenant and without constituting an eviction (constructive or otherwise), and without entitling Tenant to any abatement of Rent or to terminate this Lease or otherwise releasing Tenant from any of Tenant’s obligations under this Lease, to take any of the following actions (each, a “Reconfiguration”):

(1) Reconfigure the property line between Parcel 1 and Parcel 2, and between Parcel 3 and Parcel 2, even if such reconfiguration would cause a reduction in the size of the Land, so long as the portions of the Land on which the Buildings (and any required setbacks) are located are not affected by such action, the remaining Parcel 2 continues to be in compliance with all applicable Laws (as defined in Subparagraph 7(a) [Tenant’s Compliance Obligations]) (including, without limitation, city parking

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requirements and other development approvals), Tenant’s use of the Premises as contemplated by this Lease is not impaired thereby, and Tenant continues to have use of the Minimum Parking in accordance with Paragraph 36 [Parking].

(2) Subdivide the Land into two or more legal parcels, so long as Tenant’s use of the Premises as contemplated by this Lease is not impaired thereby and Tenant continues to have use of the Minimum Parking in accordance with Paragraph 36 [Parking].

Landlord shall deliver written notice to Tenant of Landlord’s intent to Reconfigure, identifying the portion of Parcel 2 affected by the Reconfiguration and including a new Exhibit “B” reflecting such Reconfiguration. Any Reconfiguration shall be effective on the date designated by Landlord in its notice to Tenant. On the effective date of such Reconfiguration, the description of the Land shall automatically be revised, and the terms and conditions of the original Lease shall remain in full force and effect except that the revised Exhibit “B” reflecting the location of the newly configured Land and/or additional improvements shall become part of this Lease. From and after the date of such Reconfiguration, the term “Land” shall mean the reconfigured space. The Base Rent shall not be revised as a result of any Reconfiguration. Tenant shall cooperate with Landlord in any subdivision or lot line adjustment process in connection with any Reconfiguration, provided that Tenant shall not be required to incur any out-of-pocket cost in connection with such cooperation. Upon Landlord’s request, Tenant shall execute and deliver any documents or instruments reasonably required in connection with the Reconfiguration, or the amendment of the Lease or any subdivision or lot line adjustment process in connection therewith.

(d) Additional Construction on Parcel 2. Landlord reserves the right, without incurring any liability to Tenant and without constituting an eviction (constructive or otherwise), and without entitling Tenant to any abatement of Rent or to terminate this Lease or otherwise releasing Tenant from any of Tenant’s obligations under this Lease, to construct additional buildings and improvements on Parcel 2, so long as Tenant’s use of the Premises as contemplated by this Lease is not impaired thereby, Tenant continues to have use of the Minimum Parking in accordance with Paragraph 36 [Parking], and Parcel 2 continues to be in compliance with all applicable Laws (including, without limitation, city parking requirements and other development approvals). Tenant acknowledges that during any such construction, Landlord, tenants of such additional buildings (if any), and their respective employees, contractors and agents will require access across and through the Common Area and use of portions of the Common Area for construction staging. Landlord shall not be liable to Tenant for any interference with Tenant’s use of the Common Area with respect to such construction activities or any noise, vibration, or other disturbance to Tenant’s business at the Premises which may result from such activities, so long as the Buildings’ structural components and Building Systems are not materially adversely affected by such activities and Landlord takes commercially reasonable steps to minimize any material adverse effect on Tenant’s use of the Premises during such activities. Tenant shall cooperate with Landlord in connection with any construction activities within the Project, including, without limitation, by cooperating in any parking restrictions and limitations during such activities. Without limiting the foregoing, Tenant is aware that Landlord has approval from the City of Mountain View to construct an additional building of approximately 69,038 square feet (“Building 8”) and a parking garage in the areas generally shown on Exhibit “D”, subject to certain conditions, restrictions and additional governmental approvals. Landlord makes no representation or commitment to Tenant as to whether or when Landlord will construct either Building 8 or the parking garage.

2. OCCUPANCY AND USE. Tenant shall use and occupy the Premises for the purpose specified in the Basic Lease Information and for no other use or purpose without the prior written consent of Landlord. Landlord may grant or withhold consent to a proposed change of use in its sole discretion. Notwithstanding anything in this Lease, Tenant’s use and occupancy of the Premises and Common Area will be subject at all times to the terms and conditions of the CC&Rs and the Declaration.

3. TERM AND POSSESSION.

(a) Term; Commencement Date; Expiration Date. The term of this Lease (the “Term”) shall commence at 12:01 a.m. on the date immediately following the day on which the Existing Lease expires pursuant to the

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Termination Agreement (the “Commencement Date”); provided that the Commencement Date shall not occur until such time as Netscape has delivered exclusive possession of all of the Buildings to Tenant as required under the Side Agreement. Unless sooner terminated as herein provided, this Lease shall expire on the Expiration Date. Tenant acknowledges that Netscape currently occupies portions of the Premises pursuant to the Existing Lease and that Netscape has agreed for Tenant’s benefit to deliver the Premises on a schedule set forth in the Side Agreement, with delivery of the entire Premises on or before December 31, 2003 (the “Scheduled Delivery Date”). This Lease shall not be void or voidable as a result of Netscape’s failure to vacate and/or surrender the Premises on or before the Scheduled Delivery Date, nor shall Landlord be liable to Tenant for any loss or damage resulting therefrom; provided, however, that if the Commencement Date does not occur on or before March 1, 2004, unless otherwise agreed by the parties in a signed writing, this Lease shall automatically terminate and be of no further force or effect.. Simultaneously with Netscape’s delivery of exclusive possession of the Premises to Tenant, the Tenant shall execute and deliver to Landlord a certificate certifying that Tenant has accepted delivery of the Premises and delivered the Letter of Credit (as defined below) to Landlord, in the form attached hereto as Exhibit “E” (the “Closing Certificate”), and Tenant’s execution and delivery of such Closing Certificate to Landlord shall be deemed Tenant’s representation that all conditions to the Commencement Date (other than the expiration of the term of the Existing Lease) have occurred. In addition, after the Commencement Date, Tenant shall execute a letter confirming the Commencement Date, in the form of Exhibit “F” (the “Commencement Date Memorandum”) within one (1) business day after receipt of same from the Landlord, provided that either party’s failure to request execution of, or to execute, the Commencement Date Memorandum shall not in any way alter the Commencement Date.

(b) No Representations/Obligations. Tenant acknowledges that Landlord has not made any representation or warranty with respect to the construction of Buildings or the condition of the Premises or the Common Area or with respect to the suitability or fitness of either for the conduct of Tenant’s permitted use or for any other purpose, except as may be expressly and specifically provided herein. The Premises are leased to Tenant in their “as is” condition existing on the Commencement Date. Landlord shall have no obligation to complete any alterations, improvements, repairs or decorations to the Premises either prior to the Commencement Date or during the Term. Upon Tenant’s request, Landlord shall use reasonable efforts to enforce any then-effective warranties furnished to Landlord by Landlord’s general contractor, Landlord’s architect, and any other persons in connection with the provision of labor and/or material for the Building (including the roof membrane). If Tenant is not satisfied with Landlord’s actions in enforcing such warranties, Tenant may upon written notice to Landlord take any actions necessary in Tenant’s reasonable judgment to enforce such warranties directly, and Landlord shall take all commercially reasonable action to cooperate with Tenant, including assigning to Tenant Landlord’s rights with respect to such warranties.

(c) Occupancy By Tenant. Tenant shall be deemed to occupy the Premises from and after the Commencement Date. This Paragraph 3(c) shall not be construed as an obligation of Tenant to continuously occupy the Premises.

4. RENT; RENT ADJUSTMENTS; ADDITIONAL CHARGES FOR EXPENSES AND TAXES.

(a) Payment of Rent.

(1) Monthly Base Rent. Commencing on the Rent Commencement Date (as defined in the Basic Lease Information), Tenant shall pay to Landlord throughout the Term Base Rent in an amount equal to the Monthly Base Rent specified in Paragraph 4(b) (“Base Rent”). Base Rent shall be payable by Tenant on or, at Tenant’s election, before the first day of each month, in advance, in lawful money of the United States (without any prior demand therefor and without deduction or offset whatsoever, except for abatement as may be expressly and specifically provided for in Paragraphs 22 [Damage and Destruction] and 23 [Eminent Domain]), to Landlord at the address specified in the Basic Lease Information or to such other firm or at such other place as Landlord may from time to time designate in writing.

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(2) Additional Charges and Other Rent. Tenant shall pay all charges and other amounts whatsoever as provided in this Lease (“Additional Charges”) to Landlord at the place where the Base Rent is payable, and Landlord shall have the same remedies for a default in the payment of Additional Charges as for a default in the payment of Base Rent. Additional Charges shall include, without limitation, Tenant’s obligation to pay Additional Charges for Expenses and Taxes pursuant to Paragraph 4(c) below, which shall commence on the later of the Commencement Date and January 1, 2004. As used herein, the term “Rent” shall include all Base Rent and Additional Charges (including, without limitation, Additional Charges pursuant to Paragraph 5 [Management] and Paragraph 25 [Right of Landlord to Perform]).

(3) Partial Months. If the Commencement Date or the Rent Commencement Date occurs on a day other than the first day of a calendar month, or the Expiration Date occurs on a day other than the last day of a calendar month, then the Base Rent and/or Additional Charges (as applicable) for such fractional month shall be prorated by multiplying the Monthly Base Rent and/or Additional Charges by a fraction, the numerator of which shall be (A) the actual number of days remaining in such month including and after the Rent Commencement Date or Commencement Date, as applicable, if determining Rent for the fractional first month, or (B) the actual number of days elapsed in such month prior to and including the Expiration Date, if determining Rent for the fractional last month, and the denominator of which shall be the actual number of days in such month.

(b) Base Rent Schedule. Base Rent (but not Additional Charges) shall abate during the period of time from the Commencement Date to and including June 30, 2004 (“Rent Abatement Period”). From and after July 1, 2004 (“Rent Commencement Date”) and throughout the Term, Subtenant shall pay Base Rent in the amounts set forth below:

Payment Period	Rental Rate/SF/Month-NNN
Commencement Date-June 30, 2004*	$1.15*
July 1, 2004-December 31, 2004	$1.15, or $290,432.50 per month
Calendar Year 2005	$1.18, or $298,009.00 per month
Calendar Year 2006	$1.21, or $305,585.50 per month
Calendar Year 2007	$1.24, or $313,162.00 per month
Calendar Year 2008	$1.27, or $320,738.58 per month
Calendar Year 2009	$1.31, or $330,840.50 per month
Calendar Year 2010	$1.35, or $340,942.50 per month
Calendar Year 2011	$1.39, or $351,044.50 per month
Calendar Year 2012	$1.43, or $361,146.50 per month
January 1, 2013-Expiration Date	$1.47, or $371,248.58 per month

* Base Rent (but not Additional Charges) shall abate, pursuant to the first sentence of this Paragraph 4(b), through June 30, 2004.

(c) Additional Charges for Expenses and Taxes.

(i) Definitions of Certain Additional Charges. For purposes of this Subparagraph 4(c), the following terms shall have the meanings hereinafter set forth:

(A) “Tax Year” shall mean each twelve (12) consecutive month period commencing July 1st of the calendar year during which the Commencement Date of this Lease occurs.

(B) “Real Estate Taxes” shall mean all taxes, assessments and charges levied upon or with respect to Parcel 2 or any personal property of Landlord used in the operation thereof, or Landlord’s interest in Parcel 2 or such personal property. Real Estate Taxes shall include, without limitation, all general real property taxes, possessory interest taxes, and general and special assessments, charges, fees or assessments for transit (including, without limitation, shuttle fees

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and roadways), housing, police, fire, utilities, sewers, emergency response or other governmental services or purported benefits to Parcel 2 (provided, however, that any refunds of Real Estate Taxes paid by Tenant shall be credited against Tenant’s further obligation to pay Real Estate Taxes during the Term or refunded to Tenant at the end of the Term), service payments in lieu of taxes, and any tax, fee or excise on the act of entering into this Lease, or any other lease of space in Parcel 2, or on the use or occupancy of Parcel 2 or any part thereof, or on the rent payable under any lease or in connection with the business of renting space in Parcel 2, that are now or hereafter levied or assessed against Landlord by the United States of America, the State of California, or any political subdivision, public corporation, district or any other political or public entity, and shall also include any other tax, fee or other excise, however described, that may be levied or assessed as a substitute for, or as an addition to, in whole or in part, any other Real Estate Taxes, whether or not now customary or in the contemplation of the parties on the date of this Lease. Real Estate Taxes shall not include franchise, transfer, inheritance or capital stock taxes or income taxes measured by the net income of Landlord from all sources unless, due to a change in the method of taxation, any of such taxes is levied or assessed against Landlord as a substitute for, or as an addition to, in whole or in part, any other tax that would otherwise constitute a Real Estate Tax. Additionally, Real Estate Taxes shall not include any assessments or like charges to pay for any remediation of contamination from any Hazardous Materials other than liens, assessments and like charges resulting from Tenant’s failure to pay any costs for which Tenant has indemnified Landlord pursuant to Subparagraph 39(b) [Tenant Indemnity]. Real Estate Taxes shall also include reasonable legal fees, costs and disbursements incurred in connection with proceedings to contest, determine or reduce Real Estate Taxes. If any assessments are levied on Parcel 2 and Landlord pays the assessment in full, Tenant shall have no obligation to pay more than the amount of annual installments of principal and interest that would become due during the Lease Term had Landlord elected to pay the assessment in installment payments.

(C) “Expenses” shall mean the total costs and reasonable expenses paid or incurred by Landlord in connection with the management, operation, maintenance and repair of Parcel 2, including, without limitation, (i) the cost of fire, extended coverage, boiler, sprinkler, commercial general liability, property, rent, earthquake, flood, and all other insurance obtained by Landlord pursuant to Subparagraph 12(e) [Landlord’s Insurance Obligations] including, without limitation, insurance premiums and any deductible amounts paid by Landlord; (ii) the cost of air conditioning, electricity, steam, heating, mechanical, ventilating, water, gas, elevator systems and all other utilities, the cost of supplies and equipment and maintenance and service contracts in connection therewith, and the cost of refuse and recycling services, parking lot sweeping and similar maintenance services; (iii) the cost of repairs and general maintenance and cleaning; (iv) fees, charges and other costs for any project engineers for the Project, and fees, charges and costs of all independent contractors (including attorneys, accountants and consultants) engaged by Landlord and related solely to the operation of Parcel 2 (or, if any such costs, fees and charges are attributable to other property managed by Landlord, the portion of such costs, fees and charges allocable to Parcel 2, as reasonably determined by Landlord); (v) the cost of any capital improvements made to the Building or the Common Areas as required or permitted by this Lease (including, without limitation, any costs incurred in order to comply with the Declaration in connection with such improvements); (vi) a management fee for Landlord’s management and administrative services in connection with Parcel 2 in the amount of two percent (2%) of Base Rent and Additional Charges (excluding the management fee); (vii) any expenses allocated to Parcel 2 under the CC&Rs and expenses incurred by Landlord (or its agent) for management of the Common Area pursuant to Paragraph 5 [Management]; (viii) any other expenses of any other kind whatsoever incurred in managing, operating, maintaining and repairing the Premises and/or Common Areas, including Common Area Expenses (as defined in Paragraph 5(a). Common Area Expenses shall include, without limitation, the Tenant’s share of “Project Common Expenses”, which shall mean any expenses paid or incurred by Landlord in connection with the management,

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operation, maintenance and repair of the Common Areas and other common areas in the Project and any other Expenses paid or incurred by Landlord for the benefit of the Project as a whole, including, but not limited to, the cost of maintaining the parking lot and facilities and landscaping and costs incurred by Landlord in connection with the Hetch Hetchy Easement. Project Common Expenses shall be allocated among the tenants and occupants of the Project based on the rentable area leased to or occupied by each such tenant or occupant, divided by the total leased or occupied rentable area of the Project, all as determined by Landlord in its reasonable discretion. Notwithstanding anything to the contrary herein contained, Expenses shall not include, and in no event shall Tenant have any obligation to pay for pursuant to this Subparagraph 4(c) or Subparagraph 9(c) [Repair and Maintenance; Tenant’s Obligations], (aa) the initial construction cost of Buildings; (bb) the cost of providing tenant improvements to any other tenant in Parcel 2; (cc) debt service (including, but without limitation, interest and principal) required to be made on debt incurred by Landlord and relating to the Project; (dd) ground lease payments; (ee) the portion of a management fee paid to Landlord or an affiliate in excess of two percent (2%) of the sum of Base Rent and Additional Charges (excluding the management fee); (ff) the cost of special services, goods or materials provided to any other tenant; (gg) depreciation; (hh) costs for which Landlord has a right to receive reimbursement from others; (ii) costs occasioned by Landlord’s fraud or willful misconduct under applicable Laws; (jj) costs arising from a disproportionate use of any utility or service supplied by Landlord to any other occupant of the Project to the extent that Landlord has the ability to charge such other tenant for said costs under the terms of a lease comparable to terms governing said costs in this Lease; (kk) environmental pollution remediation related costs (provided that such exclusion shall not limit Tenant’s indemnity pursuant to Subparagraph 39(b) [Hazardous Materials, Tenant Indemnity]); (ll) any maintenance, repair or replacement costs for which Landlord is responsible pursuant to Subparagraph 9(a) [Repair and Maintenance; Landlord’s Obligations (Landlord’s Cost)]; (mm) advertising or promotional costs; (nn) leasing commissions; (oo) reserves for expenses; and (pp) costs to correct any construction defects in the original construction of the Base Building Improvements for any of the Buildings or the Common Area to the extent such costs are covered by third party warranties. All costs and expenses shall be determined on a cash basis, with accruals appropriate to Landlord’s business. Expenses shall not include specific costs incurred for the account of, separately billed to and paid by specific tenants in Parcel 2.

(D) “Expense Year” shall mean each twelve (12) consecutive month period commencing January 1 of the calendar year during which the Commencement Date of the Lease occurs. Landlord, upon notice to Tenant, may change the Expense Year from time to time to any other twelve (12) consecutive month period, and, in the event of any such change, Expenses shall be equitably adjusted for the Expense Years involved in any such change.

(ii) Payment of Real Estate Taxes.

(A) Payment as Due. With reasonable promptness after Landlord has received the tax bills for any Tax Year, Landlord shall furnish Tenant with a statement (herein called “Landlord’s Tax Statement”) setting forth the amount of Real Estate Taxes for such Tax Year. Unless otherwise required pursuant to clause (B) below, Tenant shall pay to Landlord actual Real Estate Taxes in installments, twice each Tax Year (or, at Tenant’s option, in one annual payment after receipt of Landlord’s Tax Statement), no later than fifteen (15) business days prior to the due date of each Real Estate Tax installment (or, if making one annual payment, 15 business days prior to the due date of the initial installment).

(B) Impounds. Notwithstanding clause (A) above, if required by any Mortgagee or, at Landlord’s election, after any default by Tenant in the timely payment of Real Estate Taxes, Tenant shall pay to Landlord as Additional Charges one-twelfth (1/12th) of Real Estate Taxes for each Tax Year on or before the first day of each month during such Tax Year, in advance, in an

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amount reasonably estimated by Landlord and billed by Landlord to Tenant. Landlord shall have the right initially to determine monthly estimates and to revise such estimates from time to time. If the actual Real Estate Taxes for such Tax Year (as shown on Landlord’s Tax Statement) exceed the estimated Real Estate Taxes paid by Tenant for such Tax Year, Tenant shall pay to Landlord the difference between the amount paid by Tenant and the actual Real Estate Taxes within fifteen (15) days after the receipt of Landlord’s Tax Statement, and if the total amount paid by Tenant for any such Tax Year shall exceed the actual Real Estate Taxes for such Tax Year, such excess shall be credited against the next installment of Real Estate Taxes due from Tenant to Landlord hereunder. If it has been determined that Tenant has overpaid Real Estate Taxes during the last year of the Lease Term, then Landlord shall reimburse Tenant for such overage on or before the thirtieth (30th) day following the Expiration Date.

(iii) Payment of Expenses.

(A) Monthly Payments. Tenant shall pay to Landlord as Additional Charges one-twelfth (1/12th) of the Expenses for each Expense Year on or before the first day of each month of such Expense Year, in advance, in an amount reasonably estimated by Landlord and billed by Landlord to Tenant; provided, however, that all insurance premiums which are included in Expenses may, at Tenant’s option, be paid annually, in advance, within twenty (20) days after Tenant’s receipt from Landlord of a copy of the invoice with respect to such premiums. Landlord shall have the right initially to determine monthly estimates and to revise such estimates from time to time. With reasonable promptness after the expiration of each Expense Year, Landlord shall furnish Tenant with a statement (herein called “Landlord’s Expense Statement”), setting forth in reasonable detail the Expenses for such Expense Year. If the actual Expenses for such Expense Year exceed the estimated Expenses paid by Tenant for such Expense Year, Tenant shall pay to Landlord the difference between the amount paid by Tenant and the actual Expenses within fifteen (15) days after the receipt of Landlord’s Expense Statement, and if the total amount paid by Tenant for any such Expense Year shall exceed the actual Expenses for such Expense Year, such excess shall be credited against the next installment of the estimated Expenses due from Tenant to Landlord hereunder or if the Term has ended it shall be returned to Tenant within thirty (30) days. If Tenant has overpaid Expenses during the last year of the Lease Term, then Landlord shall reimburse Tenant for such overage on or before the thirtieth (30th) day following the later of the Expiration Date or the end of the last Expense Year. To the extent any item of Expenses is payable by Landlord in advance of the period to which it is applicable (e.g. insurance and tax escrows required by any Mortgagee), or to the extent that prepayment is customary for the service or matter, Landlord may (aa) include such items in Landlord’s estimate for periods prior to the date such item is to be paid by Landlord, and (bb) to the extent Landlord has not collected the full amount of such item prior to the date such item is to be paid by Landlord, Landlord may include the balance of such full amount in a revised monthly estimate for Additional Charges.

(B) Other. If either the Commencement Date or the Expiration Date shall occur on a date other than the first day of a Tax Year and/or Expense Year, Real Estate Taxes and Expenses for the Tax Year and/or Expense Year in which the Commencement Date or the Expiration Date occurs shall be prorated.

(iv) Audit Rights. Within ninety (90) days after receipt of any Landlord’s Expense Statement or Landlord’s Tax Statement, Tenant shall have the right to audit, at Landlord’s office located in the San Francisco Bay Area, at Tenant’s expense, Landlord’s accounts and records relating to Expenses and Real Estate Taxes. Such audit shall be conducted by an independent certified public accountant approved by Landlord, which approval shall not be unreasonably withheld so long as such accountant is not being paid on a contingency fee or similar basis. If such audit reveals that Landlord has overcharged Tenant, Tenant shall notify Landlord within one hundred twenty (120) days after the date the applicable Landlord’s Expense Statement or Landlord’s Tax Statement was received by Tenant.

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Landlord may dispute such audit by arbitration pursuant to Paragraph 40 [Arbitration of Disputes]. If Landlord does not dispute such amount, or if Tenant prevails in any such arbitration, the amount overcharged shall be paid to Tenant within thirty (30) days thereafter, together with interest thereon at the “prime rate” of interest announced by the Wall Street Journal for Wells Fargo Bank (or, if Wells Fargo Bank ceases to exist, by another bank mutually acceptable to Landlord and Tenant), from the date Landlord’s Expense Statement or Landlord’s Tax Statement, as applicable, was delivered to Tenant until payment of the overcharge is made to Tenant. In addition, if Landlord’s Expense Statement or Landlord’s Tax Statement, as applicable, exceeds the actual Expenses and Real Estate Taxes which should have been charged to Tenant by more than five percent (5%), the cost of the audit shall be paid by Landlord. If Tenant fails to object to any Landlord’s Expense Statement or Landlord’s Tax Statement within one hundred twenty (120) days after receipt thereof, such statement shall be final and shall not be subject to any audit, challenge or adjustment.

(d) Late Charges; Default Rate. Tenant recognizes that late payment of any Base Rent or Additional Charges will result in administrative expenses to Landlord, the extent of which additional expense is extremely difficult and economically impractical to ascertain. Tenant therefore agrees that if any Base Rent or Additional Charges remain unpaid ten (10) days after such amount is due, the amount of such unpaid Base Rent or Additional Charges shall be increased by a late charge to be paid to Landlord by Tenant, as an Additional Charge, in an amount equal to five percent (5%) (or such greater amount not to exceed six percent (6%) if a higher rate is charged by any Mortgagee for a late payment of a monthly mortgage payment) of the amount of the delinquent Base Rent or Additional Charges. In addition, any outstanding Base Rent, Additional Charges, late charges and other outstanding amounts shall accrue interest at an annualized rate of the greater of 10% or The Ninth Circuit Federal Reserve Discount Rate plus 5% (the “Default Rate”), until paid to Landlord. Tenant agrees that such amount is a reasonable estimate of the loss and expense to be suffered by Landlord as a result of such late payment by Tenant and may be charged by Landlord to defray such loss and expense. The provisions of this Subparagraph 4(e) shall not relieve Tenant of the obligation to pay Base Rent or Additional Charges on or before the date they are due, or affect Landlord’s remedies pursuant to Subparagraph 21(b) [Landlord’s Remedies] if any Base Rent or Additional Charges are unpaid after they are due.

5. MANAGEMENT.

(a) Management by Landlord. Landlord shall act as property manager for the Common Area, and shall manage and maintain certain portions of the Premises, as set forth in Subparagraphs 9(a) and 9(b), throughout the Term, and all costs incurred by Landlord in connection with such management and maintenance described in Subparagraph 9(a) shall be deemed Additional Charges payable by Tenant in accordance with Subparagraph 4(c) [Additional Charges for Expenses and Taxes], subject to the limitations contained in Paragraph 4(c). All such costs related to the Common Area shall be defined herein as the “Common Area Expenses”.

(b) Third Party Management. If Landlord does not cure any breach of Landlord’s obligations under clause (i) of Paragraph 9(a) [Landlord’s Obligations (Landlord’s Cost)] or under clause (i) of Paragraph 9(b) [Landlord’s Obligations (Tenant’s Cost)] during the cure period provided in Subparagraph 21(c) [Landlord’s Default], Tenant may elect, by delivery of written notice to Landlord, to require that a third party manager assume management of the Premises. Within ten (10) business days after receipt of Tenant’s notice, Landlord shall provide to Tenant a list of at least three (3) third party management companies which are acceptable to Landlord, and Tenant shall chose one to manage the Premises, which manager shall be subject to any Mortgagee’s prior approval, and the management contract with such manager shall be assigned to Mortgagee at Mortgagee’s request. Each of such proposed management companies shall be reputable, with sufficient financial capability to perform the obligations of the Project manager and with sufficient experience managing similar projects in the South Bay Area, all in Landlord’s reasonable judgment. After receipt of written notice from Tenant designating the manager, Landlord shall use commercially reasonable efforts to enter into a property management contract with such manager in a timely manner.

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(c) Dispute of Assumption of Management. If a dispute arises between the parties in connection with the assumption of management by a third party management company, as applicable, pursuant to this Paragraph 5, and such dispute is submitted to arbitration in accordance with Paragraph 40 [Arbitration of Disputes], prior to the resolution of such matter by arbitration the disputed assumption of management shall not proceed, with any required transfer of management and/or other required adjustments made after the matter is ultimately determined by arbitration.

6. RESTRICTIONS ON USE. Tenant acknowledges that the Premises and Common Areas may not be used or operated in violation of the requirements of the Declaration or the CC&Rs, and Hazardous Materials may not be used or located on the Premises or Common Area in a manner which would adversely affect Landlord’s rights and benefits under the Seller Indemnity described in Subparagraph 39(d) [Seller Indemnity] (all such documents are collectively referred to as the “Restrictive Documents”); provided, however, that the parties agree that Tenant’s permitted use under this Lease and parking rights under Paragraph 36 [Parking] do not violate the Restrictive Documents. Landlord has listed certain specific uses and activities that are prohibited on all or certain portions of the Premises and Common Area pursuant to the Restrictive Documents on Exhibit “G” attached hereto. In addition, Landlord shall have the right to modify Exhibit “G” to add other restrictions on use and activities on the Premises and Common Area under the Restrictive Documents, by written notice to Tenant, so long as such restrictions do not materially adversely affect Tenant’s permitted use of the Premises, Tenant’s Minimum Parking or Tenant’s access to the Premises. Tenant shall not use the Premises or Common Area in a manner in violation of the requirements listed on Exhibit “G”, as it may be amended by Landlord from time to time in accordance with the preceding sentence, and upon written notice from Landlord Tenant shall discontinue any such use of the Premises or Common Area. In addition, Tenant shall not do or permit anything to be done in or about the Premises or Common Area which will obstruct or interfere with the Clean-up Facilities, or with the rights of any parties to the Declaration or the CC&Rs or any other tenant or occupant in the Project, or injure them, nor use or allow the Premises or Common Area to be used for any unlawful purpose, nor shall Tenant cause or maintain or permit any nuisance in, on or about the Premises or Common Area. Tenant shall not commit or suffer the commission of any waste in, on or about the Premises or Common Area. Landlord acknowledges that, for purpose of this Paragraph, the existence of the Existing Hazardous Materials (as defined in Paragraph 39 [Hazardous Materials Liability]) on the Project on the Commencement Date, and Tenant’s failure to remediate such Existing Hazardous Materials, shall not be a violation of Tenant’s obligations under this Paragraph 6 with respect to nuisance or waste.

7. COMPLIANCE WITH LAWS.

(a) Tenant’s Compliance Obligations. Tenant shall promptly, at its sole expense, maintain the Premises, any Alterations permitted hereunder and Tenant’s use and operations thereon in strict compliance at all times with all present and future laws, statutes, ordinances, resolutions, regulations, proclamations, orders or decrees of any municipal, county, state or federal government or other governmental or regulatory authority with jurisdiction over the Project, or any portion thereof, whether currently in effect or adopted in the future and whether or not in the contemplation of the parties hereto (collectively, “Laws”), and shall not do or permit anything to be done by Tenant Parties within the Common Area which will in any way conflict with or cause a violation of Laws. Such Laws shall include, without limitation, all Laws relating to health and safety (including, without limitation, the California Occupational Safety and Health Act of 1973 and the California Safe Drinking Water and Toxic Enforcement Act of 1986, including posting and delivery of notices required by such Laws with respect to the Premises and Common Area) and disabled accessibility including, without limitation, the Americans with Disabilities Act, 42 U.S.C. section 12101 et seq., Environmental Laws, and all present and future life safety, fire, sprinkler, seismic retrofit, building code and municipal code requirements; provided however, that Tenant’s obligation to comply with Environmental Laws is subject to the terms and conditions of Paragraph 39 [Hazardous Materials Liability], and Tenant shall not be responsible for compliance with clean-up provisions of any Environmental Laws except to the extent of any release caused or permitted by the Tenant Parties or otherwise included in Tenant’s indemnity contained in Subparagraph 39(b) [Hazardous Materials Liability; Tenant Indemnity]. Notwithstanding the

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foregoing, Tenant shall not be required to make any structural alterations to the building exterior walls and windows, foundation, floors, roof membrane, roof system, raised shell sprinklers, related structural components, unenclosed secondary stairwells, and the slab components and subgrade specifications providing structural support and reductions in vapor transmission as more particularly described in that certain letter from Perry Palmer to Ed Axelson, dated January 14, 1997, and attached hereto as Exhibit “H” (all of the foregoing collectively, the “Base Building Improvements”), or to the Common Area, in order to comply with Laws unless the requirement that such alterations be made is triggered by any of the following (or, if such requirement results from the cumulative effect of any of the following when added to other acts, omissions, negligence or events, to the extent such alterations are required by any of the following): (i) the installation, use or operation of any Alterations, or any of Tenant’s trade fixtures or personal property; (ii) the acts, omissions or negligence of Tenant, or any of its servants, employees, contractors, agents or licensees; or (iii) the particular use or particular occupancy or manner of use or occupancy of the Premises or Common Area by Tenant, or any of its servants, employees, contractors, agents or licensees (collectively, “Tenant Parties”). The parties acknowledge and agree that Tenant’s obligation to comply with all Laws as provided in this paragraph (subject to the limitations contained herein) is a material part of the bargained-for consideration under this Lease. Tenant’s obligations under this Paragraph shall include, without limitation, the responsibility of Tenant to make substantial or structural repairs and alterations to the Premises (including the Base Building Improvements, Tenant Improvements, and any Alterations) to the extent provided above, regardless of, among other factors, the relationship of the cost of curative action to the Rent under this Lease, the length of the then remaining Term hereof, the relative benefit of the repairs to Tenant or Landlord, the degree to which the curative action may interfere with Tenant’s use or enjoyment of the Premises, and the likelihood that the parties contemplated the particular Law involved. Tenant waives any rights now or hereafter conferred upon it by any existing or future Law to terminate this Lease, to receive any abatement, diminution, reduction or suspension of payment of Rent, or to compel Landlord to make any repairs to comply with any such Laws, on account of any occurrence or situation arising during the Term.

(b) Insurance Requirements. Tenant shall not do or permit anything to be done in or about the Project or bring or keep anything therein which will cause a cancellation of any insurance on the Project or otherwise violate any requirements, guidelines, conditions, rules or orders with respect to such insurance. Tenant shall at its sole cost and expense promptly comply with the requirements of the board of fire underwriters or other similar body now or hereafter constituted relating to or affecting the condition, use or occupancy of the Premises or the Common Area (other than in situations where compliance involves repair, maintenance or replacement of items that Landlord is expressly required to repair, maintain or replace under this Lease).

(c) No Limitation on Obligations. The provisions of this Paragraph 7 shall in no way limit Tenant’s maintenance, repair and replacement obligations under Paragraph 9 [Repair and Maintenance], or Tenant’s obligation to pay Expenses under Paragraph 4(c) [Additional Charges for Expenses and Taxes]. The judgment of any court of competent jurisdiction or the admission of Tenant in an action against Tenant, whether Landlord is a party thereto or not, that Tenant has so violated any such Law shall be conclusive of such violation as between Landlord and Tenant.

8. ADDITIONAL ALTERATIONS.

(a) Landlord’s Alterations. Landlord shall not be permitted to make or suffer to be made any additional alterations, additions or improvements in, on or to the Buildings or any part thereof without the prior written consent of Tenant, except as may be required by Law or as expressly required or permitted by this Lease.

(b) Landlord’s Consent to Tenant’s Alterations. Tenant shall not make or suffer to be made any additional alterations, additions or improvements (the “Alterations”) in, on or to the Premises or Common Area or any part thereof, without the prior written consent of Landlord, including, without limitation, the Initial Alterations (which shall all be made only in accordance with this Paragraph 8 and shall be included in the definition of Alterations for all purposes under this Lease). Failure of Landlord to give its disapproval to any Alterations within fifteen (15) calendar days after receipt of Tenant’s written request for approval shall

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constitute approval by Landlord of such Alterations so long as Tenant’s request includes the following statement in capitalized and boldfaced letters: BY FAILING TO RESPOND TO THIS REQUEST WITHIN FIFTEEN DAYS, YOU WILL BE DEEMED TO HAVE APPROVED THE TENANT’S INSTALLATION OF THE ALTERATIONS DESCRIBED IN THIS REQUEST. Any Alterations in, on or to the Premises or Common Areas, except for Tenant’s movable furniture and equipment, trade fixtures and Alterations which may be removed without damage to the Premises, shall become the property of Landlord upon their completion without compensation to Tenant. Landlord shall not unreasonably withhold its consent to Alterations that (i) do not materially affect the structure of the Buildings, the Building Systems (as defined below) or the Buildings’ security or other systems; (ii) are not visible from the exterior of the Buildings; (iii) are consistent with Tenant’s permitted use hereunder; and (iv) comply with the Declaration; the CC&Rs; any easements, licenses or other use agreements or encumbrances on Landlord’s title to the Land (including, without limitation, any underground easements in favor of PG&E or AirProducts); and any Mortgage.

(c) Permitted Alterations. Notwithstanding Subparagraph 8(b), Tenant may make Alterations to the Premises (but not the Common Area, or the interior courtyard or roof of any Building) without Landlord’s prior consent so long as (x) such Alterations comply with items (i) through (iv) in Paragraph 8(b) [Landlord’s Consent to Tenant’s Alterations], (y) such Alterations do not require underground digging, and (z) the cost of each such Alteration (or group of Alterations, if occurring substantially at the same time and as part of a single project) does not exceed Fifty Thousand Dollars ($50,000), and the cost of all such Alterations in any twelve (12) month period during the Term in the aggregate does not exceed One Hundred Thousand Dollars ($100,000) (any such Alterations being defined herein as “Permitted Alterations”).

(d) Requirements for Tenant Alterations. Tenant shall make any Alterations consented to or permitted under this Paragraph 8 at Tenant’s sole cost and expense, in compliance with the following requirements: (i) Alterations (other than Permitted Alterations) shall be made in accordance with plans and specifications reasonably approved by Landlord, and all Alterations shall be made in accordance with the requirements of Paragraph 10 [Liens]; (ii) any contractor or person selected by Tenant to make Alterations (other than Permitted Alterations) must first be approved in writing by Landlord, in its reasonable discretion; (iii) Alterations shall be made in compliance with all applicable Laws; (iv) Alterations shall not alter or interfere with the ceiling of any Building (all partitions being below the ceiling grid, except in areas designated by Landlord on plans and specifications), unless approved by Landlord in its sole discretion; and (v) Alterations shall not cause more than fifty percent (50%) of the rentable floor area on any floor in any Building to be enclosed as hard wall office unless approved by Landlord in its sole discretion; provided, however, that Tenant may make Alterations that do not comply with the standards set forth in items (iv) and (v) above (subject to any other applicable Landlord consent requirement) if Tenant agrees to reconfigure the affected floor to such standard upon expiration or earlier termination of this Lease. By making Alterations which do not comply with the standards set forth in items (iv) and (v) above, Tenant shall be deemed to have agreed to reconfigure the Premises upon expiration or termination of the Lease as provided above unless Landlord specifically agrees otherwise in writing. Upon completion of any Alterations (other than Permitted Alterations), Tenant shall furnish Landlord with a complete set of final as-built plans and specifications, at Tenant’s cost and expense. If Tenant fails to provide Landlord with any such final as-built plans and specifications within one hundred twenty (120) days after completion of the applicable Alterations, Landlord may, at Landlord’s election, cause such final as-built plans and specifications to be prepared at Tenant’s cost and expense, and the expenses thereof incurred by Landlord shall be reimbursed as Additional Charges within thirty (30) days after submission of a bill or statement therefor. With respect to items (i) and (ii) above, failure of Landlord to give its disapproval to any plans and specifications or general contractor within fifteen (15) calendar days after receipt of Tenant’s written request for approval shall constitute approval by Landlord of such matters so long as Tenant’s request includes the following statement in capitalized and boldfaced letters: BY FAILING TO RESPOND TO THIS REQUEST WITHIN FIFTEEN DAYS, YOU WILL BE DEEMED TO HAVE APPROVED THE PLANS AND SPECIFICATIONS AND/OR GENERAL CONTRACTOR FOR TENANT’S ALTERATIONS DESCRIBED IN THIS REQUEST.

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(e) Removal of Alterations and Restoration. Upon the expiration or sooner termination of the Term, Tenant shall upon demand by Landlord, at Landlord’s election, either (i) at Tenant’s sole cost and expense, forthwith and with all due diligence remove any Alterations made by or for the account of Tenant that are designated by Landlord to be removed and restore the Premises to its original condition as of the Commencement Date, subject to normal wear and tear and the rights and obligations of Tenant concerning casualty damage pursuant to Paragraph 22 [Damage and Destruction], or (ii) pay Landlord the reasonable estimated cost thereof as required by Subparagraph 26(b) [Delivery and Restoration of Premises]. Upon the written request of Tenant prior to installation of any Alterations, Landlord shall notify Tenant of its election to require that such Alterations must be removed upon the expiration or sooner termination of this Lease, so long as such written request clearly requests Landlord’s election regarding the removal of such Alterations. Landlord’s failure to specifically notify Tenant of Landlord’s election shall be deemed Landlord’s election to require removal of the Alterations upon expiration of the Term, notwithstanding any deemed approval by Landlord of the Alterations pursuant to this paragraph.

(f) Reimbursement of Landlord’s Review Costs. Tenant shall reimburse Landlord upon demand for any reasonable out-of-pocket expenses incurred by Landlord in connection with the review of any Alterations made by Tenant, including reasonable fees charged by Landlord’s contractors or consultants to review plans and specifications prepared by Tenant.

9. REPAIR AND MAINTENANCE.

(a) Landlord’s Obligations (Landlord’s Cost). Landlord shall maintain, repair and replace, at its sole cost and expense, the following, except as provided in Subparagraph 9(d) [Tenant’s Obligations for Structural Maintenance] below: (i) the roof structure (but not the roof membrane) and structural portions of the Buildings (including load bearing walls and foundations); (ii) all underground plumbing owned by Landlord from the point of connection to the City of Mountain View’s main line to the point of entry into each of the Buildings; and (iii) structural portions of the parking facilities in Parcel 2, to the extent the required maintenance, repair or replacement results from defects in the original design or construction of the parking facilities (but not including resurfacing, pothole repair or a new slurry seal, if required by use of the parking facilities or from other causes).

(b) Landlord’s Obligations (Tenant’s Cost). Landlord shall maintain, repair and replace (i) the exterior of each Building, and (ii) parking areas and structures, courtyards, sidewalks, entry ways, lawns, landscaping and other similar facilities of the Buildings and Common Areas. Tenant shall be responsible for all costs incurred by Landlord in connection with Landlord’s obligations under this Paragraph 9(b), which costs shall be payable by Tenant as Additional Charges in accordance with Paragraph 3(c) to the extent they are properly included in Expenses thereunder. Tenant shall notify Landlord in writing within fifteen (15) days (or immediately by telephone or facsimile in the event of emergency, with prompt confirmation delivered in accordance with Paragraph 28 [Notices]) after Tenant becomes aware of any circumstances which Tenant believes may trigger Landlord’s obligations under Subparagraph 9(a) or 9(b). Landlord shall not be in breach of its obligations under Subparagraph 9(a) or 9(b) with respect to any particular repair, replacement or maintenance requirement unless and until Landlord has received such written notice from Tenant and had sufficient opportunity to satisfy such obligations. Tenant shall be liable to Landlord for any additional cost incurred by Landlord in satisfying such obligations, or any damage to the Project, resulting from Tenant’s failure to timely notify Landlord of such circumstances as required by this paragraph. Tenant shall cooperate with Landlord in connection with Landlord’s repair, maintenance and replacement activities pursuant to Paragraphs 9(a) and (b), including, without limitation, by cooperating in any reasonable temporary parking restrictions and limitations and/or other reasonable limitations on use of the Common Areas during such activities.

(c) Tenant’s Obligations. Tenant shall maintain, repair and replace, at its sole cost and expense, all portions of the Premises which are not listed under Subparagraphs 9(a) and 9(b), including, without limitation, (i) the roof membrane, (ii) the Building systems for electrical, mechanical, HVAC and plumbing and all controls appurtenant thereto (collectively, “Building Systems”), and (iv) the interior portion of the

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Buildings, the Tenant Improvements, the Alterations, and any additional tenant improvements, alterations or additions installed by or on behalf of Tenant within the Premises. Parcel 2 shall at all times be maintained in the condition of a first-class office and research and development park. Without limiting the foregoing, the Building Systems shall be maintained in accordance with certain standards and a maintenance schedule which shall be provided by Landlord, at Landlord’s option, in accordance with commercially reasonable recommendations of Landlord’s landscaping and/or building contractors, manufacturers and/or consultants. If and when Landlord provides maintenance standards and schedule for the Building Systems, Tenant agrees to review the maintenance standards and schedule proposed by Landlord within ten (10) business days following the date they are submitted by Landlord to Tenant and to notify Landlord, in writing, of any objections to the standards and schedule, in Tenant’s reasonable discretion. If Tenant fails to notify Landlord of any objection within such ten (10) business day period, Tenant shall be deemed to have approved the proposed standards and schedule. If Tenant objects to the proposed standards and schedule and the parties are unable to resolve Tenant’s objections, either party may submit such dispute to arbitration pursuant to Paragraph 40 [Arbitration of Disputes], provided that prior to the resolution of such matter by arbitration, Tenant shall maintain the Project in accordance with Landlord’s proposed standards and schedule. The maintenance standard and schedule which are placed into effect pursuant to this paragraph shall be added to the Lease as Exhibit “I”, and may be amended by Landlord from time to time during the Term, by delivering written notice thereof to Tenant, subject to Tenant’s approval in its reasonable discretion in accordance with the procedure set forth in this paragraph. Tenant’s obligations under this Paragraph 9 include, without limitation, the replacement, at Tenant’s sole cost and expense, of any portions of Parcel 2 which are not Landlord’s express responsibility under Subparagraph 9(a) or 9(b), if it would be commercially prudent to replace, rather than repair, such portions of Parcel 2, regardless of whether such replacement would be considered a capital expenditure. Tenant hereby waives and releases its right to make repairs at Landlord’s expense under Sections 1941 and 1942 of the California Civil Code or under any similar law, statute or ordinance now or hereafter in effect. In addition, Tenant hereby waives and releases its right to terminate this Lease under Section 1932(1) of the California Civil Code or under any similar law, statute or ordinance now or hereafter in effect.

(d) Tenant’s Obligations for Structural Maintenance. Notwithstanding the provisions of Subparagraph 9(a) [Landlord’s Obligations (Landlord’s Cost)] and without limiting Tenant’s other obligations hereunder, Tenant shall bear the full cost of structural repairs or maintenance to preserve the Buildings in good working order and condition, to the extent such structural repair and/or maintenance is required due to the following (except to the extent any claims arising from any of the following are reimbursed by insurance carried by Landlord, are covered by the waiver of subrogation in Paragraph 13 [Waiver of Subrogation] or are otherwise provided for in Paragraph 22 [Damage and Destruction]): (i) the installation, use or operation of any Alterations or other modification to the Premises or Common Area made by Tenant; (ii) the installation, use or operation of Tenant’s property or fixtures; (iii) the moving of Tenant’s property or fixtures in or out of any Building or in and about the Project; or (iv) the acts, omissions or negligence of Tenant, or any of its servants, employees, contractors, agents or licensees, or the particular use or particular occupancy or manner of use or occupancy of the Premises or Common Area by Tenant or any such person. In addition, if at any time during the Term Hazardous Materials are released, discharged, or disposed of on any portion of the Premises or Common Area, in violation of Tenant’s obligations hereunder, repairs of the storm drains and/or plumbing from the point of connection to the City of Mountain View’s main line to the point of entry into each of the Buildings shall be excluded from Landlord’s obligations under this Paragraph 9. Tenant shall not cause or permit any disposal or release of Hazardous Substances into the plumbing systems at the Project. Prior to Tenant’s performance of any structural repairs or maintenance required under this paragraph, the parties shall agree on the scope of the required structural repair or maintenance, and shall agree upon which alternative method is appropriate if more than one alternative exists. If the parties are unable to agree on the scope or alternative, despite reasonable efforts, such dispute shall be submitted to arbitration pursuant to Paragraph 40 [Arbitration of Disputes]; provided, however, that if the failure to make any such structural repair or maintenance during the pendency of such arbitration would have a material, detrimental effect on the condition or operation of any Building, Tenant shall either (x) delay the activity which would trigger the

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required structural repair or maintenance, or (y) if such activity already has occurred or cannot be delayed, commence and diligently pursue the required structural repair or maintenance based on the scope and alternative (if more than one) specified by Landlord, with a reasonable adjustment to be made by the parties after the matter is ultimately determined by arbitration.

(e) Maintenance Service Contracts. In connection with Tenant’s maintenance and repair obligations contained in this Paragraph 9, Tenant shall, at its own cost and expense, enter into regularly scheduled preventive maintenance service contracts with maintenance contractors approved by Landlord, in its reasonable discretion, for servicing all hot and cold water, heating, air conditioning and electrical systems, elevators and equipment within the Buildings, and shall provide copies of such contracts to Landlord. At Landlord’s option at any time in which Tenant is in default hereunder, maintenance service contracts shall be prepaid by Tenant on an annual basis. Tenant shall use commercially reasonable efforts to cause each maintenance service contract to specifically name Landlord as a third party beneficiary, with the right to receive copies of all notices delivered under such contract and the ability to exercise Tenant’s rights thereunder upon Tenant’s default under this Paragraph 9, at Landlord’s election. If Tenant is unable, despite such efforts, to include such rights in any maintenance service contract, Tenant agrees to itself provide Landlord with copies of notices delivered under such contract, and at Landlord’s election Tenant shall assign Tenant’s rights under such contract to Landlord upon Landlord’s exercise of its rights under Subparagraph 9(f) [Cure Rights].

(f) Cure Rights. Tenant shall have a period of thirty (30) days from the date of written notice from Landlord within which to cure any failure to fulfill any of its obligations under this Paragraph 9; provided, however, that if such failure is curable but cannot be cured within such thirty (30) day period, Tenant shall have such additional time as may be reasonably required to cure so long as Tenant commences such cure within the initial thirty (30) day period and diligently prosecutes such cure to completion. If Tenant fails to cure such failure as provided above, or in the event of an emergency which materially adversely affects the Project, Landlord may, at Landlord’s election, cure such failure (including, without limitation, by exercising Tenant’s rights under any maintenance service contract), at Tenant’s cost and expense, and the expenses thereof incurred by Landlord shall be reimbursed as Additional Charges within thirty (30) days after submission of a bill or statement therefor. The remedies described in this paragraph constitute Landlord’s exclusive remedies if Tenant fails to maintain, repair or replace any portions of the Premises or Common Area in accordance with its obligations under this Paragraph 9; provided, however, that nothing contained in this Subparagraph 9(f) shall limit Landlord’s right to receive reimbursement for attorneys’ fees or waive or affect Tenant’s indemnity and insurance obligations under this Lease and Landlord’s rights to those indemnity and insurance obligations

(g) No Liability of Landlord. There shall be no abatement of Rent with respect to, and Landlord shall not be liable for any injury to or interference with Tenant’s business arising from, any repairs, maintenance, alteration or improvement in or to any portion of the Project or the Clean-up Facilities by any party, except as expressly and specifically provided in Paragraph 22 [Damage and Destruction], provided, however that (i) Base Rent and Additional Charges may be abated during the period of any interference to Tenant’s business which exceeds ninety (90) days, in proportion to the portion of the Premises Tenant is unable to use, only if such interruption results from an insured casualty such that proceeds are payable to Landlord under the rental interruption insurance carried by Landlord pursuant to Subparagraph 12(e) [Landlord’s Insurance Obligations] and only to the extent of such proceeds actually received by Landlord, and (ii) subject to the limitations on Tenant’s recourse against Landlord contained in Subparagraph 21(d) [Tenant’s Remedies], Landlord shall be liable for any actual damage to Tenant to the extent caused by Landlord’s gross negligence or willful misconduct in connection with any such repairs, maintenance, alteration or improvement.

10. LIENS. Tenant shall keep the Project free from any liens arising out of any work performed, material furnished or obligations incurred by Tenant, including, without limitation, the Initial Alterations. If Tenant does not, within thirty (30) days following notice by Landlord of any such lien, cause it to be released of record by payment or posting of a proper bond (or such shorter period of time as may be required to avoid a default under

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any Mortgage), Landlord shall have, in addition to all other remedies provided herein and by law, the right, but not the obligation, to cause it to be released by such means as Landlord deems proper, including payment of the claim giving rise to such lien. All sums paid and expenses incurred by Landlord in connection therewith shall be considered Additional Charges and shall be payable to Landlord by Tenant on demand, with interest at the Default Rate. Landlord shall have the right at all times to post and keep posted on the Premises and Common Area any notices permitted or required by law or by any Mortgagee, for the protection of the Premises, the Buildings, the Land, the Common Area, the Project, Landlord, any Mortgagee, and any other party having an interest in any portion of the Project from mechanics’ and materialmen’s liens. Tenant shall give Landlord at least five (5) business days’ prior notice of commencement of any construction on the Premises or Common Area other than Permitted Alterations. This Paragraph 10 shall survive any termination of this Lease.

11. ASSIGNMENT AND SUBLETTING.

(a) Restriction on Assignment and Subleasing. Tenant shall not directly or indirectly, voluntarily, by a change of control transaction, or by operation of law, (i) sell, assign, encumber, pledge or otherwise transfer or hypothecate all or any part of the Premises, the Tenant Improvements, the Initial Alterations, any additional Alterations or Tenant’s leasehold estate hereunder (collectively, “Assignment”), or (ii) sublet the Premises or any portion thereof or otherwise permit the Premises to be occupied by anyone other than Tenant (collectively, “Sublease”), without Landlord’s prior written consent to each Assignment or Sublease, which consent shall not be unreasonably withheld or delayed by Landlord; provided, however, that Landlord may withhold its consent, in its sole discretion, to any Assignment which affects less than the entire Premises, or any Sublease which would result in more than two (2) separate entities (including Tenant and any subtenants or other occupants) occupying any floor in any Building. Without otherwise limiting the criteria upon which Landlord may withhold its consent to any proposed Sublease or Assignment, if Landlord withholds its consent where either (i) the creditworthiness of the proposed Sublessee or Assignee is not reasonably acceptable to Landlord or any Mortgagee, or (ii) the proposed Sublessee’s or Assignee’s use of the Premises is not in compliance with the allowed Tenant’s Use of the Premises as described in the Basic Lease Information or, in Landlord’s judgment, would require or result in presence of Hazardous Materials on the Premises and/or Common Area in excess of those described in Subparagraph 39(f) [Tenant’s Disclosure Obligations], such withholding of consent shall be presumptively reasonable. If Landlord consents to the Sublease or Assignment, Tenant may thereafter enter into a valid Sublease or Assignment upon the terms and conditions set forth in this Paragraph 11. As used herein, “change of control transaction” shall mean any transaction or series of transactions resulting in (i) the transfer of control of Tenant, other than by reason of death, or, (ii) if Tenant is a corporation, the direct or indirect change in the control of Tenant or in the ownership by the stockholders or an affiliated group of stockholders of fifty percent (50%) or more of the outstanding stock as of the date of the execution and delivery of this Lease. As used in this Paragraph 11, “control” means the power to direct or cause the direction of the day-to-day management and policies of a company, whether through the ownership of voting securities, or partnership or membership interests, by contract, by interlocking boards of directors, or otherwise. Notwithstanding anything to the contrary contained in this Lease, any transfer or issuance of stock over the New York Stock Exchange, the American Stock Exchange, or NASDAQ shall not be deemed an assignment, subletting or other transfer of this Lease or the Premises requiring Landlord’s consent for purposes of this Paragraph 11.

(b) Required Notice. If Tenant desires at any time to enter into an Assignment of this Lease or a Sublease of the Premises or any portion thereof, it shall first give written notice to Landlord containing (i) the name of the proposed assignee, subtenant or occupant; (ii) a description of the proposed assignee’s, subtenant’s, or occupant’s business and activities to be carried on in the Premises; (iii) the terms and provisions of the proposed Assignment or Sublease; and (iv) such financial information as Landlord may reasonably request concerning the proposed assignee, subtenant or occupant.

(c) Landlord’s Response To Proposed Assignment. Within fifteen (15) days after Landlord’s receipt of the notice specified in Subparagraph 11(b) [Required Notice] with respect to an Assignment of Tenant’s interest under this Lease, Landlord may by written notice to Tenant elect to (i) terminate this Lease,

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(ii) consent to the Assignment, or (iii) disapprove the Assignment. Notwithstanding anything in this Subparagraph 11(c) to the contrary, Landlord shall not have the right to terminate this Lease in connection with any “Permitted Transfer” (as defined below).

(d) Landlord’s Response To Proposed Sublease. Within fifteen (15) days after Landlord’s receipt of the notice specified in Subparagraph 11(b) [Required Notice] with respect to a Sublease, Landlord may by written notice to Tenant elect to (i) sublease itself the portion of the Premises specified in Tenant’s notice; (ii) consent to the Sublease; or (iii) disapprove the Sublease. Notwithstanding anything in this Subparagraph 11(d) to the contrary, Landlord shall not have the rights set forth in (i) and (iii) of this Subparagraph 11(d) in connection with any Sublease to a “Strategic Partner” (as defined below) in compliance with Subparagraph 11(h) [Strategic Partners]. If Landlord elects to Sublease from Tenant as described in clause (i) above, the Monthly Base Rent payable by Landlord shall be the rent set forth in Tenant’s notice (which shall be allocated between Landlord and Tenant in accordance with Subparagraph 11(e) [Bonus Rent]). If Landlord exercises the option set forth in clause (i) above with respect to a portion of the Premises, Landlord shall have the right to further sublease that portion of the Premises at Landlord’s election without the consent of Tenant.

(e) Bonus Rent. If Landlord consents to any Assignment or Sublease pursuant to Subparagraph 11(c) [Landlord’s Response To Proposed Assignment] or Subparagraph 11(d) [Landlord’s Response To Proposed Sublease], Tenant may within one hundred twenty (120) days after Landlord’s consent, but not later than the expiration of said one hundred twenty (120) days, enter into such Assignment or Sublease of the Premises or portion thereof upon the terms and conditions set forth in the notice furnished by Tenant to Landlord pursuant to Subparagraph 11(b) [Required Notice]. However, fifty percent (50%) of all “Net Profits” (as defined in the next sentence) realized by Tenant under any such Assignment or Sublease shall be paid to Landlord as and when received by Tenant. As used herein, “Net Profits” shall mean any sums received by Tenant in excess of the amounts payable by Tenant to Landlord (including Base Rent and Additional Charges), on a per-square-foot basis, for the applicable term pursuant to this Lease after deducting from such excess only the actual and reasonable, third-party, out of pocket expenses incurred by Tenant in connection with such Assignment or Sublease, together with the actual, fair market rental or sales proceeds received by Tenant that are equitably allocable to the sale or rental of Tenant’s personal property (but not to the Initial Alterations or to any furniture, fixtures or equipment conveyed to Tenant by Netscape that are affixed to the Premises) to the assignee or sublessee (all such deducted expenses and proceeds shall be referred to herein as the “Deducted and Unrelated Costs”). All Deducted and Unrelated Costs shall be amortized, on a straight-line basis (without interest), over the period commencing on the date such costs are incurred and expiring on the Expiration Date. Tenant shall use commercially reasonable efforts to provide Landlord reasonable advance notice of Tenant’s calculations of any Net Profits and Deducted and Unrelated Costs but, in all cases, shall have an obligation to provide Landlord such calculations on or before the date of delivery to Landlord of the assignment or sublease agreement for which Landlord’s consent is requested hereunder. Failure by Landlord to either consent or refuse such consent to a proposed Assignment or Sublease within the fifteen (15) day time period specified above shall be deemed to be Landlord’s consent thereto.

(f) Effect of Transfer. Landlord’s consent to any Assignment or Sublease shall not relieve Tenant of any obligation to be performed by Tenant under this Lease, whether arising before or after the Assignment or Sublease. Landlord’s consent to any Assignment or Sublease shall not relieve Tenant from the obligation to obtain Landlord’s express written consent to any other Assignment or Sublease. Any Assignment or Sublease that is not in compliance with this Paragraph 11 shall be void and, at the option of Landlord, shall constitute a material default by Tenant under this Lease. The acceptance of Base Rent or Additional Charges by Landlord from a proposed assignee or sublessee shall not constitute the consent to such Assignment or Sublease by Landlord.

(g) Permitted Transfer. The following shall be deemed a voluntary Assignment of Tenant’s interest in this Lease: (i) any dissolution, merger, consolidation, or other reorganization of Tenant; and (ii) if the capital stock of Tenant is not publicly traded, the sale or transfer of stock to one person or entity possessing or controlling more than fifty percent (50%) of the total combined voting power of all classes of Tenant’s

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stock issued, outstanding and entitled to vote for the election of directors. Notwithstanding anything to the contrary contained in this Paragraph 11, Tenant may enter into any of the following transfers (a “Permitted Transfer”) without Landlord’s prior written consent: (1) Tenant may assign its interest in the Lease to a corporation which results from a merger, consolidation or other reorganization, so long as immediately following such transaction the surviving corporation satisfies each of the Credit Standards; and (2) Tenant may assign this Lease to a corporation which purchases or otherwise acquires all or substantially all of the assets of Tenant, so long as immediately following such transaction such acquiring corporation satisfies each of the Credit Standards. “Credit Standards” shall mean each of the following, as reflected in audited financial statements (which include an unqualified certification by a licensed certified pubic accountant reasonably acceptable to Landlord) provided to Landlord: (a) a tangible net worth of at least One Hundred Eighty Million Dollars ($180,000,000); (b) a ratio of current assets to current liabilities of at least 1.75:1; (c) unencumbered and unrestricted cash and cash equivalents of the greater of One Hundred Million Dollars ($100,000,000) or five percent (5%) of Tenant’s total assets; (d) a ratio of debt to equity (on an historic cost basis) not in excess of 2:1; and (e) no operating losses (exclusive of losses due to acquisitions) for the prior two (2) years (combined operations of pre-existing entities). Notwithstanding any such assignment, the original Tenant shall remain liable for performance and compliance with all of the terms, conditions and provisions of this Lease. After a Permitted Transfer, the surviving entity shall promptly execute and deliver to Landlord an agreement in form reasonably satisfactory to Landlord under which such surviving entity assumes the obligations of Tenant hereunder. If, after a Permitted Transfer described in clause (2) above, the stock of the surviving Tenant is no longer publicly traded, then the acquiring corporation in such Permitted Transfer (the “Acquiring Entity”) shall promptly execute and deliver to Landlord a guaranty of lease in form reasonably satisfactory to Landlord under which the Acquiring Entity guarantees the full payment and performance of the obligations of Tenant under this Lease (the “Lease Guaranty”). The foregoing notwithstanding, if the Acquiring Entity is itself not a publicly-traded corporation, but is instead the subsidiary of a publicly-traded corporation (or a subsidiary in a chain of entities in which a parent corporation is publicly traded), then the publicly-traded parent corporation shall be required to execute and deliver to Landlord the Lease Guaranty. In addition, if after such acquisition Tenant no longer prepares audited financial statements, then in addition to the financial statements required to be delivered by Tenant hereunder, the entity required to execute the Lease Guaranty shall provide Landlord its audited financial statements at the times and in the manner required of Tenant hereunder. It is the intent of the parties that after a Permitted Transfer, Landlord shall be entitled to rely on the creditworthiness of a publicly-traded corporation and to receive audited financial information from a publicly-traded corporation.

(h) Strategic Partners. Tenant may Sublease portions of the Premises to Tenant’s Strategic Partners (as defined below) without Landlord’s prior consent, subject to the following conditions: (1) after any such Sublease, Tenant shall continue to directly occupy at least eighty percent (80%) of the Rentable Area in the Premises; and (2) Tenant shall provide Landlord with written notice at least thirty (30) days’ prior to any such Sublease including the name of the Strategic Partner, the location of the subleased space, the name and address of the Strategic Partner’s agent for service of process and delivery of notices under this Lease, and a certification by an officer of Tenant that the subtenant is a “Strategic Partner” as defined in this Subparagraph 11(h). Any Strategic Partner subleasing a portion of the Premises shall maintain an agent for service of process and notice, and notify Landlord of any changes in such agent, at all times during the term of such sublease. The term “Strategic Partner” shall refer to any entity (i) in which Tenant holds an unsubordinated ownership interest of at least ten percent (10%), (ii) that is engaged in a business which Tenant believes to be of strategic importance to its own business, and (iii) that Tenant determines, in its reasonable business judgment, would benefit Tenant’s business by conducting its own business within Tenant’s Premises.

(i) Assumption by Transferee. Each assignee, sublessee or other transferee, other than Landlord, shall assume all obligations of Tenant under this Lease arising after the date of transfer, as provided in this Subparagraph 11(i), and shall be and remain liable jointly and severally with Tenant for the payment of Base Rent and Additional Charges, and for the performance of all the terms, covenants, conditions and agreements herein contained on Tenant’s part to be performed for the Term; provided, however, that the

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assignee, sublessee, mortgagee, pledgee or other transferee shall be liable to Landlord for rent only in the amount set forth in the Assignment or Sublease and shall only be required to perform those obligations under the Lease to the extent that they relate to the portion of the Premises subleased or interest in the Lease assigned. Any Sublease or Assignment shall expressly provide that if this Lease terminates, the subtenant or assignee will attorn to and become the tenant of the Landlord at the option of Landlord if Landlord elects to recognize such assignment or sublease upon such termination. No Assignment shall be binding on Landlord unless the assignee or Tenant delivers to Landlord a counterpart of the Assignment and an instrument that contains a covenant of assumption by the assignee satisfactory in substance and form to Landlord, consistent with the requirements of this Subparagraph 11(i), but the failure or refusal of the assignee to execute such instrument of assumption shall not release or discharge the assignee from its liability as set forth above.

12. INSURANCE AND INDEMNIFICATION.

(a) Release of Landlord. Landlord shall not be liable to Tenant, and Tenant hereby waives all claims against Landlord Parties for any injury or damage to any person or property in or about the Premises or Common Area by or from any cause whatsoever (other than the gross negligence or willful misconduct of Landlord or its agents, servants, contractors or employees (collectively, including Landlord, “Landlord Parties”)), and without limiting the generality of the foregoing, whether caused by water leakage of any character from the roof, walls, or other portion of the Buildings or Common Area, or caused by gas, fire, oil, electricity, or any cause whatsoever, in, on, or about the Project or any part thereof (other than that caused by the gross negligence or willful misconduct of Landlord Parties). Tenant acknowledges that any casualty insurance carried by Landlord will not cover, and Landlord shall not be responsible for, loss of income to Tenant or damage to the Alterations in the Premises installed by Tenant or Tenant’s personal property located within the Premises, including, without limitation, during construction of any Alterations. Tenant shall be required to maintain the insurance described in Subparagraph 12(c) [Tenant’s Insurance Requirements] below during the Term.

(b) Tenant Indemnity. Except to the extent caused by the gross negligence or willful misconduct of the Landlord Parties, Tenant shall indemnify and hold the Landlord Parties harmless from and defend the Landlord Parties against any and all claims or liability for any injury or damage to any person or property whatsoever occurring in or on the Premises, including, without limitation, as a result of biological agents, mold or fungus. Tenant further agrees to indemnify and hold the Landlord Parties harmless from, and defend the Landlord Parties against, any and all claims, losses, or liabilities (including damage to Landlord’s property) arising from (x) any breach of this Lease by Tenant and/or (y) the conduct of any work, business or activities of Tenant, its agents, servants, employees, or invitees (collectively, including Tenant, “Tenant Parties”), in or about the Project.

(c) Tenant’s Insurance Requirements. Tenant shall procure at its cost and expense and keep in effect during the Term (including, without limitation, during the course of construction of any Alterations) the following insurance:

(i) Commercial General Liability Insurance. A policy of Commercial General Liability insurance written on an occurrence form, insuring Landlord, any Mortgagee, Tenant, any manager under the CC&Rs, and any other entity with an interest in any portion of the Common Area if designated by Landlord, against any liability arising out of the ownership, use, occupancy, maintenance, repair or improvement of the Premises or the Common Area and as appurtenant thereto. Such insurance shall provide $5,000,000 combined single limit for bodily injury and property damage. The limits of said insurance shall not, however, limit the liability of the Tenant hereunder, and Tenant is responsible for ensuring that the amount of liability insurance carried by Tenant is sufficient for Tenant’s purposes. Tenant may carry said insurance under a blanket policy so long as “per location” liability aggregate limit is maintained, satisfactory to Landlord. If Tenant shall fail to procure and maintain said insurance, Landlord may, but shall not be required to, procure and maintain same, but at the expense of Tenant. In addition, Landlord may elect, at Landlord’s sole option, to procure and maintain liability insurance

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with respect to the Common Area, at the expense of Tenant. Tenant shall deliver to Landlord prior to occupancy of the Premises copies of policies of liability insurance required herein, and certificates evidencing the existence and amounts of such insurance which name as additional insured Landlord, any Mortgagee, any manager under the CC&Rs, and any other entity with an interest in any portion of the Common Areas if designated by Landlord, with evidence satisfactory to Landlord and any such parties of payment of premiums. No policy shall be cancelable except after ten (10) days’ prior notice or subject to reduction of coverage except after thirty (30) days’ prior written notice to Landlord.

(ii) Time Element Insurance. Business income and extra expense insurance, insuring Tenant for a period of eighteen (18) months against losses arising from the interruption of Tenant’s business, and for lost profits, and charges and expenses which continue but would have been earned if the business had gone on without interruption, insuring against such perils, in such form as is reasonably satisfactory to Landlord. Such insurance should be without deductible in excess of forty-eight (48) hours and on an agreed amount basis with no coinsurance payable.

(iii) Property Insurance. Tenant shall maintain a policy or policies of fire and property damage insurance under “special form” causes of loss (formerly known as “all risk”), also with an earthquake sprinkler leakage endorsement, and including earthquake insurance, insuring any Alterations (to the extent not insured by Landlord as provided in Subparagraph 12(e) below), the personal property, inventory, trade fixtures, and if applicable boiler and machinery, within the Premises for the full replacement value thereof. The proceeds from any of such policies shall be used for the repair or replacement of such items so insured. Tenant acknowledges and agrees that insurance coverage carried by Landlord will not cover Tenant’s property within the Premises and that Tenant shall be responsible, at Tenant’s sole cost and expense, for providing insurance coverage for Tenant’s movable equipment, furnishings, trade fixtures and other personal property in or upon the Premises and for any alterations, additions or improvements to or of the Premises or any part thereof made by Tenant, in the event of damage or loss thereto from any cause whatsoever.

(iv) Course of Construction Insurance. During the course of construction of any Alterations, Tenant shall purchase and keep in force Comprehensive Builder’s Risk/Course of Construction insurance, with the same requirements as property insurance policies described above but with appropriate adjustments to reflect that the Alterations are under construction.

(v) Workers Compensation Insurance. Tenant shall also maintain a policy or policies of workers’ compensation insurance and any other employee benefit insurance sufficient to comply with all Laws.

Insurance required hereunder shall be in companies rated “A” VI or better in “Best’s Insurance Guide.” Tenant shall deliver policies of such insurance or certificates thereof to Landlord on or before the Commencement Date, together with certificates which name as additional insured Landlord and any Mortgagee, and thereafter at least thirty (30) days before the expiration dates of expiring policies; and, in the event Tenant shall fail to procure such insurance, or to deliver such policies or certificates, Landlord may, at its option, procure same for the account of Tenant, and the cost thereof shall be paid to Landlord as Additional Charges within fifteen (15) days after delivery to Tenant of bills therefor. In addition, promptly following completion of construction of the Initial Alterations, and on or before each anniversary of the Commencement Date thereafter, Tenant shall deliver to Landlord a statement of values (each, a “Statement of Values”) reflecting both the value of all Alterations that Tenant requests Landlord to insure pursuant to Paragraph 12(e) and also Tenant’s insurance coverage on its personal property and Alterations that are not to be insured by Landlord pursuant to Paragraph 12(e) below.

(d) Survival. The provisions of this Paragraph 12 shall survive the expiration or termination of this Lease with respect to any claims or liability arising out of events occurring prior to such expiration or termination.

(e) Landlord’s Insurance Obligations. Landlord shall purchase and keep in force a policy or policies of liability, fire and property damage insurance, including provisions allowing the payment of deductibles (which shall be payable by Tenant pursuant to Subparagraph 4(c)) and pre-payment for coverage up to one

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year, covering loss or damage to the Premises including Tenant Improvements (and also including Alterations to the extent reflected in Tenant’s then-current Statement of Values as Alterations Tenant requests Landlord to insure) and Common Area in the amount of the full replacement value thereof (based, for purposes of the Alterations Landlord is insuring at Tenant’s request, on Tenant’s then-current Statement of Values), insuring direct physical loss or damage included within the “special form” classification of coverage and flood and earthquake insurance, if available, plus a policy of rental income insurance in the amount of eighteen (18) months Base Rent and Additional Charges and, at Landlord’s election pursuant to Subparagraph 12(c)(i) [Commercial General Liability Insurance], Commercial General Liability insurance for the Common Area. At Tenant’s request, Landlord shall include any specific Alterations allowed under this Lease in such policies, provided that Tenant provides Landlord with all information reasonably required by Landlord or its insurer in connection with such Alterations and such Alterations and their insured value are identified in Tenant’s then-current Statement of Values, and Landlord shall not be liable for any under-insurance of Alterations so long as Landlord insures the designated Alterations at the values reflected in the then-current Statement of Values. Notwithstanding anything to the contrary herein, until Tenant delivers its first Statement of Values to Landlord upon completion of the Initial Alterations, Landlord shall continue to insure the Tenant Improvements at the values Landlord is insuring under the Existing Lease as of the Effective Date, notwithstanding any demolition or alteration of such Tenant Improvements or addition of Initial Alterations. Tenant shall pay to Landlord the cost of all such policy or policies of insurance pursuant to Subparagraph 4(c) [Additional Charges for Expenses and Taxes]. If Landlord’s insurance cost is increased due to Tenant’s use of the Premises, Tenant agrees to pay to Landlord the full cost of such increase. Tenant shall have no interest in nor any right to the proceeds of any insurance procured by Landlord for the Premises or the Common Area. Notwithstanding the foregoing obligations of Landlord to carry insurance, Landlord may modify the foregoing coverages if and to the extent it is commercially reasonable to do so; provided, however, that such coverages shall not be voluntarily reduced by Landlord without Tenant’s prior consent.

13. WAIVER OF SUBROGATION. Notwithstanding anything to the contrary in this Lease, to the extent that this waiver does not invalidate or impair their respective insurance policies, the parties hereto release each other and their respective contractors, subcontractors, agents, employees, successors, assignees and subtenants, and any manager under the CC&Rs, from all liability for injury to any person or damage to any property that is caused by or results from a risk (i) which is actually insured against, to the extent of receipt of payment under such policy (unless the failure to receive payment under any such policy results from a failure of the insured party to comply with or observe the terms and conditions of the insurance policy covering such liability, in which event, such release shall not be so limited), (ii) which is required to be insured against under this Lease, or (iii) which would normally be covered by the standard ISO “special” form of casualty insurance, without regard to the negligence or willful misconduct of the entity so released. Tenant shall obtain a similar waiver of subrogation requirement in its construction contracts for any Alterations, and shall require that its contractors obtain a similar waiver from all subcontractors of all tiers. Landlord and Tenant shall each obtain, and shall cause their respective contractors and subcontractors to obtain, from their respective insurers under all policies of fire, theft and other property insurance maintained by either of them at any time during the Term (including during the course of construction of any Alterations) insuring or covering the Project or any portion thereof of its contents therein, a waiver of all rights of subrogation which the insurer of one party might otherwise, if at all, have against the other party, and Landlord and Tenant shall each indemnify the other against any loss or expense, including reasonable attorneys’ fees, resulting from the failure to obtain such waiver.

14. SERVICES AND UTILITIES.

(a) Tenant’s Responsibility. Subject to the provisions elsewhere herein contained and to the Rules and Regulations, Tenant shall be responsible for arranging for, and direct payment of any and all cost of, garbage pickup, recycling, janitorial, security, transportation management programs, water, electricity, gas, telecommunications, cable and digital communications equipment, required inspections and testing of elevators, fire sprinklers and other life safety equipment and Building Systems, and any and all other

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utilities and services. Landlord shall cooperate with Tenant’s efforts to arrange all such services, and Tenant shall provide the maintenance, repair and replacement of Building Systems in connection with such utilities and services as described in Subparagraph 9(c) [Repair and Maintenance; Tenant’s Obligations]. Tenant shall cooperate fully with Landlord and abide by all the reasonable regulations and requirements that Landlord may prescribe for the proper functioning and protection of the Building Systems.

(b) Specific Provisions regarding Electricity. Tenant acknowledges that (a) Landlord was not and is not responsible for furnishing electrical systems for, or electrical power to, any of the Buildings either pursuant to the Existing Lease or pursuant to this Lease; (b) pursuant to the Existing Lease, Netscape was responsible for furnishing and installing primary electrical service from PG&E’s point-of-connection outside the Project to a substation point on the Project, and an electrical distribution system from the substation point to and throughout each of the Buildings, as necessary for Netscape’s intended use (the foregoing collectively, the “Electrical Distribution System”); (c) Netscape installed the Electrical Distribution System in a manner that requires that electrical power to each of the Buildings and the Premises is only available through a 12 KV meter (the “Existing Meter”) located at a substation point located on Parcel 1 that also serves Parcel 1, which currently is leased to Netscape; and (d) as a condition to Landlord’s agreement to allow Netscape to install the Electrical Distribution System, Netscape agreed to certain restoration and reconfiguration obligations upon expiration or termination of the Existing Lease, which obligations are assumed by Tenant pursuant to Paragraph 26(c) of this Lease. In consideration of the foregoing, and without limiting the provisions of Paragraph 14(a), (i) Tenant shall at all times be solely responsible for providing electrical power to the Premises and Common Area and for taking all necessary action and performing all obligations associated therewith; (ii) Tenant shall be responsible, at Tenant’s sole expense, for installation (as required), operation and maintenance of the electrical distribution system and all components thereof, and telecommunications and other communications cabling and conduits, throughout Parcel 2, either through the existing Electrical Distribution System and communications cabling and conduits in existence as of the Effective Date or through such replacement or additional systems, cabling and conduits as may be required throughout the Term of this Lease, including, without limitation, any reconfiguration, upgrading, conveyancing or other action required by PG&E, PacBell and/or otherwise to allow reasonably adequate electrical power and communications services to be available to the Premises and each Building throughout the Lease Term; and (iii) Landlord shall not be responsible or liable in any way to Tenant and/or to any other party for any failure by Netscape to allow Tenant, the Premises or any of the Buildings to obtain electrical power from PG&E through the Existing Meter, or for any failure by Netscape to install the “Mercury Meter” (as defined in the Side Agreement).

(c) No Excessive Load. Tenant will not without the prior written consent of Landlord, which consent shall not be unreasonably withheld or delayed, use any apparatus or device in the Premises which, when used, puts an excessive load on any Building or its structure or systems.

(d) No Liability of Landlord. Landlord shall not be in default hereunder or be liable for any damages directly or indirectly resulting from, nor shall Rent be abated by reason of, (i) the installation, use or interruption of use of any equipment in connection with the foregoing utilities and services; (ii) the unavailability, interruption, delay or failure of any utilities (including, without limitation, electricity) or services to the Premises or Common Area which are the responsibility of Tenant under this Lease; (iii) failure to furnish or delay in furnishing any services to be provided by Landlord when such failure or delay is caused by Force Majeure Events, or by the making of repairs or improvements to Parcel 2 or any portion thereof which are the responsibility of Landlord under this Lease; or (iv) the limitation, curtailment, rationing or restriction on use of water or electricity, gas or any other form of energy or any other service or utility whatsoever serving Parcel 2 or any Building; provided, however, that (aa) Base Rent and Additional Charges may be abated during the period of any total interruption of utilities to the Premises which exceeds thirty (30) days only if such interruption results from an insured casualty such that proceeds are payable to Landlord under the rental interruption insurance carried by Landlord pursuant to Subparagraph 12(e) [Landlord’s Insurance Obligations] and only to the extent of such proceeds actually received by Landlord, and (bb) subject to the limitations on Tenant’s recourse against Landlord contained in Subparagraph 21(d)

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[Tenant’s Remedies], Landlord shall be liable for any actual damage to Tenant’s property to the extent caused by Landlord’s gross negligence or willful misconduct in connection with the failure to furnish or delay in furnishing any services to be provided by Landlord. For purposes of this Lease, “Force Majeure Events” shall mean Acts of God or the elements, Acts of the government, labor disturbances of any character, and other similar conditions, beyond the reasonable control of the party whose performance, obligation or liability is excused or delayed by such event (collectively, “Force Majeure Events”).

15. TENANT’S CERTIFICATES. Tenant, at any time and from time to time, within ten (10) days after written request from Landlord, will execute, acknowledge and deliver to Landlord and, at Landlord’s request, to any prospective purchaser, ground or underlying lessor or Mortgagee of any part of the Project or any other party acquiring an interest in Landlord, a certificate of Tenant substantially in the form attached as Exhibit “J” (with changes required to make such certificate true). The certificate may also contain any other information reasonably required by any such persons. It is intended that any certificate of Tenant delivered pursuant to this Paragraph 15 may be relied upon by Landlord and any prospective purchaser, ground or underlying lessor or Mortgagee of any part of the Project or such other party. If requested by Tenant, Landlord shall provide Tenant with a similar certificate.

16. HOLDING OVER. If Tenant (directly or through any successor-in-interest of Tenant) remains in possession of all or any portion of the Premises after the expiration or termination of this Lease without the consent of Landlord, Tenant’s continued possession shall be on the basis of a tenancy at the sufferance of Landlord. In such event, Tenant shall continue to comply with or perform all the terms and obligations of Tenant under this Lease, except that the Monthly Base Rent during Tenant’s holding over shall be the greater of the then-fair market rent for the Premises (as reasonably determined by Landlord) or one hundred twenty-five percent (125%) of the Monthly Base Rent payable in the last full month prior to the termination hereof. In addition to Rent, Tenant shall pay Landlord for all damages proximately caused by reason of the Tenant’s retention of possession. Landlord’s acceptance of Rent after such termination shall not constitute a renewal of this Lease, and nothing contained in this provision shall be deemed to waive Landlord’s right of re-entry or any other right hereunder or at law. Tenant acknowledges that, in Landlord’s marketing and re-leasing efforts for the Premises, Landlord is relying on Tenant’s vacation of the Premises on the Expiration Date. Accordingly, Tenant shall indemnify, defend and hold Landlord harmless from and against all claims, liabilities, losses, costs, expenses and damages arising or resulting directly or indirectly from Tenant’s failure to timely surrender the Premises, including (i) any loss, cost or damages suffered by, any prospective tenant of all or any part of the Premises, and (ii) Landlord’s damages as a result of such prospective tenant rescinding or refusing to enter into the prospective lease of all or any portion of the Premises by reason of such failure of Tenant to timely surrender the Premises.

17. SUBORDINATION. Without the necessity of any additional document, this Lease shall be subject and subordinate at all times to: (i) all ground leases or underlying leases that may now exist or hereafter be executed affecting any portion of the Premises or Common Area; and (ii) the lien of any mortgage or deed of trust that may now exist or hereafter be executed in any amount for which any portion of the Premises or Common Area or any ground leases or underlying leases, or Landlord’s interest or estate in any of said items, is specified as security (any such lien being herein defined as a “Mortgage” and the holder of any Mortgage being a “Mortgagee”). Notwithstanding the foregoing, Landlord shall have the right to subordinate or cause to be subordinated any such ground leases or underlying leases or any Mortgage to this Lease. If any ground lease or underlying lease terminates, or any Mortgage is foreclosed or a conveyance in lieu of foreclosure is made, for any reason, Tenant shall, notwithstanding any subordination, attorn to and become the Tenant of the successor in interest to Landlord at the option of such successor in interest. Notwithstanding anything to the contrary contained herein, this Lease shall not be subject or subordinate to any ground or underlying lease or to any lien, Mortgage, or other security interest affecting the Premises, and Tenant shall not attorn to the ground lessor, Mortgagee or other holder of the interest to which this Lease would be subordinated unless such ground lessor, Mortgagee or holder executes a reasonable recognition and non-disturbance agreement which provides that Tenant shall be entitled to continue in possession of the Premises on the terms and conditions of this Lease if and

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for so long as Tenant fully performs all of its obligations hereunder. Not later than the Commencement Date, Landlord shall obtain consent to this Lease from Teachers Insurance and Annuity Association (“Teachers”), and will use diligent good faith efforts to obtain from Teachers prior to the Commencement Date, for the benefit of Tenant, Teachers’ standard form of subordination and non-disturbance agreement in the form attached hereto as Exhibit “K”. Tenant shall execute and deliver upon demand by Landlord, and in the form requested by Landlord or any Mortgagee and reasonably acceptable to Tenant, any additional documents evidencing the priority or subordination of this Lease with respect to any such ground leases or underlying leases or the lien of any such Mortgage. Tenant shall execute, deliver and authorize recordation of any such documents within twenty (20) days after Landlord’s written request.

18. RULES AND REGULATIONS. Tenant shall faithfully observe and comply with the rules and regulations attached to this Lease as Exhibit “L” and all reasonable nondiscriminatory modifications thereof and additions thereto from time to time put into effect by Landlord, provided such rules and regulations do not unreasonably interfere with Tenant’s use of the Premises and the Common Areas as contemplated by this Lease. In the event of an express and direct conflict between the terms, covenants, agreements and conditions of this Lease and those set forth in the rules and regulations, as modified and amended from time to time by Landlord, this Lease shall control.

19. RE-ENTRY BY LANDLORD. Landlord reserves and shall at all reasonable times have the right to re-enter the Premises, upon reasonable prior notice (except in the case of an emergency), and subject to Tenant’s reasonable security precautions and the right of Tenant to accompany Landlord at all times, for the following purposes: to inspect the same; to supply any service to be provided by Landlord to Tenant hereunder (unless Tenant is supplying such service); to show the Premises to prospective purchasers, Mortgagees or tenants (as to prospective tenants other than prospective tenants of any recaptured space, only during the last twelve (12) months of the Term); to post notices of nonresponsibility; to alter, improve or repair the Premises and any portion thereof as required or allowed by this Lease or by law (and Landlord may for that purpose erect, use, and maintain scaffolding, pipes, conduits, and other necessary structures in and through the Premises where reasonably required by the character of the work to be performed); and to take, or allow other parties (including, without limitation, government entities) to take, any actions contemplated by the Declaration or the CC&Rs, or in connection with the remediation orders described in Paragraph 39 [Hazardous Materials], the Clean-Up Facilities or related monitoring or remediation of Hazardous Materials. In addition, Landlord reserves and shall at all times have the right to access and entry to the Common Area, without limitation or restriction, for all of the foregoing purposes. Landlord shall not be liable in any manner for any inconvenience, disturbance, loss of business, nuisance or other damage arising from Landlord’s or any third party’s (including without limitation pursuant to the Declaration or the CC&Rs) entry and acts pursuant to this Paragraph 19. Tenant shall not be entitled to an abatement or reduction of Base Rent or Additional Charges if Landlord exercises any rights reserved in this paragraph. Tenant hereby waives any claim for damages for any injury or inconvenience to or interference with Tenant’s business, any loss of occupancy or quiet enjoyment of the Premises, and any other loss occasioned thereby, except to the extent caused by Landlord’s gross negligence or willful misconduct. For each of the aforesaid purposes, Landlord shall have the right to use any and all means which Landlord reasonably determines are necessary or proper to open doors on the Premises in an emergency in order to obtain entry to any portion of the Premises. Any entry to the Premises, or portion thereof obtained by Landlord by any of said means, or otherwise, shall not under any emergency circumstances be construed or deemed to be a forcible or unlawful entry into, or a detainer of, the Premises, or an eviction, actual or constructive, of Tenant from the Premises or any portions thereof. Landlord shall use best efforts during re-entry to not unreasonably interfere with Tenant’s use of the Premises or its business conducted therein.

20. INSOLVENCY OR BANKRUPTCY. The appointment of a receiver to take possession of all or substantially all of the assets of Tenant, or an assignment by Tenant for the benefit of creditors, or any action taken or suffered by Tenant under any insolvency, bankruptcy, reorganization or other debtor relief proceedings, (each of the foregoing, an “Insolvency Proceeding”), whether now existing or hereafter amended or enacted, shall, at Landlord’s option, constitute a breach of this Lease by Tenant, unless a petition in bankruptcy, receiver attachment, or other remedy pursued by a third party is discharged within sixty (60) days. Upon the happening of

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any such event (including the expiration of such 60 day period, if applicable) or at any time thereafter, this Lease shall terminate five (5) days after written notice of termination from Landlord to Tenant. In no event shall this Lease be assigned or assignable by operation of law (except as provided in Paragraph 11 [Assignment and Subletting]) or by voluntary or involuntary bankruptcy proceedings or otherwise. In no event shall this Lease or any rights or privileges hereunder be an asset of Tenant under any bankruptcy, insolvency, reorganization or other debtor relief proceedings.

21. DEFAULT.

(a) Tenant’s Default. The failure to perform or honor any covenant, condition or representation made under this Lease shall constitute a “default” hereunder by Tenant upon expiration of the appropriate grace period hereinafter provided, except as expressly and specifically provided in Subparagraph 9(f) [Repair and Maintenance; Cure Rights]. Tenant shall have a period of three (3) days from the date of written notice from Landlord (which notice shall be in lieu of and not in addition to the notice required by Section 1161 of the California Code of Civil Procedure) within which to cure any default in the payment of Base Rent or Additional Charges; provided, however, that Landlord shall not be required to provide such notice more than twice during any four (4) year period during the Term with respect to non-payment of Base Rent or Additional Charges, the third such non-payment constituting default without requirement of notice. Tenant shall have a period of thirty (30) days from the date of written notice from Landlord (which notice shall be in lieu of and not in addition to the notice required by Section 1161 of the California Code of Civil Procedure) within which to cure any other curable default under this Lease; provided, however, that with respect to any curable default other than the payment of Base Rent or Additional Charges that cannot reasonably be cured within thirty (30) days, the default shall not be deemed to be uncured if Tenant commences to cure within thirty (30) days from Landlord’s notice and continues to prosecute diligently the curing thereof. Notwithstanding the foregoing, if a different cure period is specified elsewhere in this Lease with respect to any specific obligation of Tenant, such specific cure period shall apply with respect to a default of such obligation.

(b) Landlord’s Remedies. Upon an uncured default of this Lease by Tenant, Landlord shall have the following rights and remedies in addition to any other rights or remedies available to Landlord at law or in equity:

(i) The rights and remedies provided by California Civil Code, Section 1951.2, including but not limited to, recovery of the worth at the time of award of the amount by which the unpaid Base Rent and Additional Charges for the balance of the Term after the time of award exceeds the amount of rental loss for the same period that the Tenant proves could be reasonably avoided, as computed pursuant to subsection (b) of said Section 1951.2;

(ii) The rights and remedies provided by California Civil Code, Section 1951.4, that allows Landlord to continue this Lease in effect and to enforce all of its rights and remedies under this Lease, including the right to recover Base Rent and Additional Charges as they become due, for so long as Landlord does not terminate Tenant’s right to possession. Acts of maintenance or preservation, efforts to relet the Premises or the appointment of a receiver upon Landlord’s initiative to protect its interest under this Lease shall not constitute a termination of Tenant’s rights to possession;

(iii) The right to terminate this Lease by giving notice to Tenant in accordance with applicable law;

(iv) If Landlord elects to terminate this Lease, the right and power to enter the Premises and remove therefrom all persons and property, and to store such property in a public warehouse or elsewhere at the cost of and for the account of Tenant, and to sell such property and apply such proceeds therefrom pursuant to applicable California law.

(c) Landlord’s Default. Landlord shall have a period of thirty (30) days from the date of written notice from Tenant of Landlord’s default (any such notice, a “Landlord Default Notice”) to cure any default by Landlord under this Lease; provided, however, that with respect to any default that cannot reasonably be

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cured within thirty (30) days, the default shall not be deemed to be uncured if Landlord commences to cure within thirty (30) days from receipt of the Landlord Default Notice and continues to prosecute diligently the curing thereof. Tenant agrees to give any Mortgagee, by registered or certified mail, a copy of any Landlord Default Notice served upon the Landlord, provided that prior to such notice Tenant has been notified in writing of the address of such Mortgagee. If Landlord fails to cure such default within the time provided for in this Lease, then the Mortgagee shall have an additional thirty (30) days after the expiration of such cure period within which to cure such default (provided that Tenant notifies Mortgagee concurrently with Tenant’s delivery of the Landlord Default Notice to Landlord; otherwise, Mortgagee shall have thirty (30) days from the later of the date on which it receives notice of the default from Tenant and the expiration of Landlord’s cure period). If such default cannot be cured by Mortgagee within the cure period, Tenant may not exercise any of its remedies so long as Mortgagee has commenced and is diligently pursuing the remedies necessary to cure such default (including, but not limited to, commencement of foreclosure proceedings, if necessary to effect such cure).

(d) Tenant’s Remedies. If any default hereunder by Landlord is not cured within the applicable cure period provided in Subparagraph 21(b) [Landlord’s Default], Tenant’s exclusive remedies shall be an action for specific performance or action for actual damages. Tenant hereby waives the benefit of any laws granting it (A) the right to perform Landlord’s obligation, or (B) the right to terminate this Lease or withhold Rent on account of any Landlord default. Tenant shall look solely to Landlord’s interest in Parcel 2 for the recovery of any judgment from Landlord. Landlord, or if Landlord is a partnership, its partners whether general or limited, or if Landlord is a corporation, its directors, officers or shareholders, shall never be personally liable for any such judgment. Any lien obtained to enforce such judgment and any levy of execution thereon shall be subject and subordinate to any Mortgage (excluding any Mortgage which was created as part of an effort to defraud creditors, i.e. a fraudulent conveyance); provided, however that any such judgement and any such levy of execution thereon shall not be subject or subordinated to any Mortgage that is created or recorded in the Official Records of Santa Clara County after the date of the judgement giving rise to such lien. Notwithstanding the foregoing limitation of recourse to Landlord’s interest in Parcel 2, Tenant shall have the right to recover from Landlord the full amount of the Letter of Credit or any other security deposit or letter of credit provided by Tenant to Landlord pursuant to this Lease, to the extent that it is drawn upon, retained, or applied by Landlord in violation of this Lease.

22. DAMAGE AND DESTRUCTION

(a) Restoration. Subject to the termination rights set forth in Subparagraph 22(c) [Casualty at End of Term] and Subparagraph 22(d) [Mutual Termination Option], if the Premises or any portion thereof are damaged or destroyed by fire or other casualty, Tenant will promptly give written notice thereof to Landlord, and:

(i) Tenant, at Tenant’s sole cost and expense, and pursuant to the provisions of Paragraph 8 [Additional Alterations], will promptly repair, restore and rebuild the Tenant Improvements and any Alterations as nearly as possible to the condition they were in immediately prior to such damage or destruction or with such changes or alterations as may be made pursuant to Paragraph 8 [Additional Alterations]; and

(ii) To the extent that any such damage or destruction affects the Base Building Improvements, Landlord shall repair the same at Landlord’s cost.

(b) Insurance Proceeds. Subject to the provisions of Subparagraph 22(f) [Proceeds Upon Termination], all insurance proceeds recovered by the Landlord or the Tenant on account of such damage or destruction, less the cost, if any, to the Landlord of such recovery and/or of any repair to the Base Building Improvements for which Landlord is responsible, shall be paid out from time to time to or at the direction of Tenant to the extent required to repair, restore and rebuild the Tenant Improvements, the Initial Alterations, and any other Alterations covered by Landlord’s insurance as required by Subparagraph 22(a)(1) [Restoration], pursuant to disbursement procedures established by Landlord and/or any Mortgagee. The

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amount of available insurance proceeds shall not limit Tenant’s or Landlord’s obligation to repair, restore and rebuild the Tenant Improvements and Alterations and the Base Building Improvements, respectively, in accordance with this Paragraph 22.

(c) Casualty at End of Term. Notwithstanding anything to the contrary contained in this Lease, if during the twelve (12) months prior to the expiration of the Term, any of the Buildings or a substantial portion thereof are damaged or destroyed by fire or other casualty, either Tenant or Landlord shall have the option to terminate this Lease with respect to the affected Building as of the date of such damage or destruction by written notice to the other party given within thirty (30) days after such damage or destruction, in which event the Landlord shall make a proportionate refund to the Tenant of such Rent as may have been paid in advance. For the purposes of this paragraph, a “substantial portion” of a Building shall mean twenty percent (20%) or more of the Rentable Area thereof. If neither party elects to terminate this Lease, Landlord and/or Tenant shall repair, restore and rebuild the Premises in accordance with Subparagraph 22(a) [Restoration].

(d) Mutual Termination Option; Insured Casualty. Notwithstanding anything to the contrary contained herein, if at any time during the Term the Base Building Improvements for any Building shall be damaged or destroyed to the extent that, in Landlord’s reasonable judgment, they cannot be reconstructed within eighteen (18) months following the date such reconstruction is commenced, either Landlord or Tenant shall have the right to terminate this Lease as of the date of such damage or destruction with respect to the affected Building by written notice to the other party. Within forty-five (45) days after any damage or destruction described in this Subparagraph 22(d), Landlord shall either terminate the Lease with respect to the affected Building or deliver notice to Tenant advising of Landlord’s election not to so terminate. If Tenant is so notified, but Landlord does not elect to terminate, Tenant may terminate this Lease as of the date of such damage or destruction with respect to the affected Building by written notice to Landlord given within forty-five (45) days after receipt of Landlord’s notice. If neither party elects to terminate this Lease, Landlord and/or Tenant shall repair, restore and rebuild the Premises in accordance with Subparagraph 22(a) [Restoration].

(e) Destruction Where No Proceeds Are Available. Subject to Tenant’s termination right under Subparagraph 22(c) [Casualty at End of Term], in the event of a total or partial destruction of any Building (i) by a casualty of a type not required to be insured against by Landlord under the terms of this Lease, or (ii) under circumstances where Landlord has been required by any Mortgagee to utilize substantially all of the insurance proceeds to pay down the Mortgage, which destruction exceeds five percent (5%) of the replacement cost of the Base Building Improvements, this Lease shall automatically terminate, unless (x) Landlord elects to reconstruct the Base Building Improvements, and (y) the damage can be reconstructed within eighteen (18) months following commencement of reconstruction. If Landlord elects to reconstruct, the cost incurred by Landlord for such reconstruction shall be amortized over the useful life of the Base Building Improvements and such amortization shall be reimbursed by Tenant to Landlord as an Additional Charge together with interest at the prime rate of Wells Fargo Bank plus two percent (2%) (adjusted monthly); provided, however, that Tenant shall not be obligated to pay for any portion of the useful life of the Base Building Improvements which extends beyond the Expiration Date. If Landlord elects to reconstruct the Base Building Improvements, Tenant shall be obligated to reconstruct the Tenant Improvements and the Initial Alterations, at Tenant’s cost.

(f) Proceeds Upon Termination. If this Lease is terminated under Subparagraph 22(c) [Casualty at End of Term] or Subparagraph 22(d) [Mutual Termination Option; Insured Casualty] with respect to any Building(s), Landlord shall be entitled to retain any and all insurance proceeds arising out of the damage or destruction (including, without limitation, proceeds attributable to the Tenant Improvements and/or Initial Alterations, including, without limitation proceeds under policies obtained by Tenant), except for any portion of the award specifically compensating Tenant for the loss of its personal property, equipment and trade fixtures. Upon any termination, Tenant shall assign all of its rights to any insurance proceeds to which it is entitled (except any portion specifically compensating Tenant for the loss of its personal property, equipment and trade fixtures) to Landlord and shall pay to Landlord the amount of any deductible under any insurance policy attributable to the casualty resulting in such termination.

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(g) Rent Abatement. In the event of an insured casualty, the Base Rent and Additional Charges during the period from the date of the damage or destruction until completion of the restoration, repair, replacement or rebuilding shall be abated by an amount that is in the same ratio to the Base Rent and Additional Charges as the area of the Premises rendered unusable for the permitted use hereunder bears to the area of the Premises prior to the damage or destruction, but only to the extent of the amount of proceeds payable to Landlord (taking into account any applicable waiting period or deductibles) under the rental interruption insurance required to be carried by Landlord pursuant to Subparagraph 12(e) [Landlord’s Insurance Obligations].

(h) Waiver of Statutory Provisions. Tenant hereby waives the provisions of Section 1932.2, and Section 1933.4, of the Civil Code of California, or any similar laws now or hereafter in effect, that would relieve the Tenant from any obligation to pay Rent under this Lease due to any damage or destruction.

23. EMINENT DOMAIN.

(a) Entire Building. If an entire Building shall be taken or appropriated under the power of eminent domain or conveyed in lieu thereof (any such event, a “Taking”), (i) this Lease and all right, title and interest of the Tenant hereunder shall cease and come to an end on the date of vesting of title pursuant to such Taking with respect to such Building, (ii) the Base Rent and Additional Charges payable with respect to said Building shall be apportioned as of the date of such vesting, and (iii) this Lease shall be and remain unaffected with respect to any portion of the Premises not taken.

(b) Partial Building; Termination. If there is a Taking of less than an entire Building, this Lease shall terminate as to the portion of the Building so taken upon vesting of title pursuant to such Taking, and if, but only if, such Taking is so extensive that it renders the remaining portion of such Building unsuitable for the use being made of the Building on the date immediately preceding such Taking, either the Tenant or the Landlord may terminate this Lease as to the remainder of such Building by written notice to the other party not later than thirty (30) days after the date of such vesting, specifying as the date for termination a date not later than thirty (30) days after such notice. On the date specified in such notice, (i) the term of this Lease and all right, title and interest of Tenant hereunder shall cease with respect to said Building, (ii) the Base Rent and Additional Charges payable with respect to said Building shall be apportioned as of the date of such termination, and (iii) this Lease shall be and remain unaffected with respect to any Building not included in such Taking.

(c) Partial Building; Restoration. If there is a Taking of less than an entire Building and this Lease is not terminated with respect to said Building as provided in (b) above, this Lease shall terminate as to the portion of the Building so taken upon vesting of title pursuant to such Taking. In any such case, Landlord shall restore the Base Building Improvements for the portion of the Building continuing under this Lease at Landlord’s cost and expense; provided, however, that Landlord shall not be required to repair or restore any injury or damage to the property of Tenant or to make any repairs or restoration of any Tenant Improvements or Alterations installed on the Premises by or at the expense of Tenant. Tenant shall, at Tenant’s sole cost and expense, promptly and pursuant to the provisions of Paragraph 8 [Additional Alterations], restore those portions of the Tenant Improvements and Alterations not so taken. Thereafter, the Base Rent and Additional Charges to be paid under this Lease for the remainder of the Term shall be proportionately reduced, such that thereafter the amounts to be paid by Tenant with respect to such Building shall be in the ratio that the portion of the Building not so taken bears to the total area of the Building prior to such Taking.

(d) End of Term Taking. If, during the twelve (12) months prior to the expiration of the Term, there is a Taking of a portion of the Building, both Landlord and Tenant shall have the option, exercisable by written notice to the other party given within thirty (30) days after such vesting of title, of terminating this Lease with respect to said Building as of the date of vesting of title pursuant to the Taking, in which event Landlord shall make a proportionate refund to Tenant of any Base Rent and Additional Charges that have been paid in advance.

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(e) Taking of Common Area. If there is a Taking of any portion of the Common Area which causes the Premises to violate parking requirements, building setbacks or access requirements under any applicable Laws, Landlord shall cure such non-compliance by any reasonable means (including, without limitation, by a Reconfiguration). If Landlord determines that such violation is not curable by reasonable means, Landlord shall have the option, exercisable by written notice to Tenant of terminating this Lease as of the date of vesting of title pursuant to the Taking. If Landlord does not terminate this Lease pursuant to the preceding sentence and fails to commence to cure such violation within thirty (30) days after such Taking, Tenant shall have the option, exercisable by written notice to Landlord, of terminating this Lease as of the date of vesting of title pursuant to the Taking. If this Lease is terminated pursuant to this Subparagraph 23(e), Landlord shall make a proportionate refund to Tenant of any Base Rent and Additional Charges that have been paid in advance.

(f) Award. Landlord shall receive (and Tenant shall assign to Landlord upon demand from Landlord) any income, rent, award or any interest therein which may be paid in connection with any Taking, whether partial or total, and whether or not either Landlord or Tenant exercises any right it may have to terminate this Lease. Tenant shall have no claim against Landlord for any part of such sum paid by virtue of the Taking, whether or not attributable to the value of the unexpired term of this Lease. However, Tenant shall be entitled to petition the condemning authority for the following: (i) the then unamortized value of any Alterations paid for by Tenant which Tenant is required to remove upon termination of the Lease; (ii) the value of Tenant’s trade fixtures; (iii) Tenant’s relocation costs; and (iv) Tenant’s goodwill, loss of business and business interruption.

(g) Temporary Taking. Notwithstanding anything to the contrary contained in this Paragraph 23, if there is a Taking of the temporary use or occupancy of any part of the Premises during the Term, this Lease shall be and remain unaffected by such Taking and Tenant shall continue to pay in full all Base Rent and Additional Charges payable hereunder by Tenant during the Term. In such event, Tenant shall be entitled to receive that portion of any award which represents compensation for the use or occupancy of the Premises during the Term, and Landlord shall be entitled to receive that portion of any award which represents the cost of restoration of the Premises and the use and occupancy of the Premises after the end of the Term. Notwithstanding the foregoing, if Landlord determines in its reasonable judgment that any Taking of the temporary use or occupancy of any part of the Premises will continue until the end of the Term, either party may elect to terminate this Lease by written notice to the other party at any time after Landlord has made such determination and delivered written notice thereof to Tenant, and Landlord shall be entitled to receive the entire award for the Taking, except for that portion which represents compensation for the use or occupancy of the Premises during the period of time prior to such termination.

(h) Waiver of Statutory Provisions. Landlord and Tenant understand and agree that the provisions of this Paragraph 23 are intended to govern fully the rights and obligations of the parties in the event of a Taking of all or any portion of the Premises. Accordingly, the parties each hereby waives any right to terminate this Lease in whole or in part under Sections 1265.120 and 1265.130 of the California Code of Civil Procedure or under any similar Law now or hereafter in effect.

24. SALE BY LANDLORD. If Landlord sells or otherwise conveys its interest in all or any portion of the Premises, Landlord shall be relieved of its obligations under the Lease with respect to the conveyed portion from and after the date of sale or conveyance only when Landlord transfers the proportionate amount of any security deposit of Tenant to its successor and the successor assumes in writing the obligations to be performed by Landlord on and after the effective date of the transfer, whereupon Tenant shall attorn to such successor.

25. RIGHT OF LANDLORD TO PERFORM. All covenants and agreements to be performed by Tenant under any of the terms of this Lease shall be performed by Tenant at Tenant’s sole cost and expense and without any abatement of Base Rent or Additional Charges. If Tenant defaults in the payment of any sum of money, other than Base Rent or Additional Charges, required to be paid by it hereunder or fails to perform any other act on its part to be performed hereunder, and such failure continues for ten (10) days after notice thereof by Landlord (or

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such longer period as noted in Subparagraph 9(f) [Cure Rights] or Subparagraph 21(a) [Tenant’s Default], except in the event of emergency), Landlord may, but shall not be obligated to, make any such payment or perform any such act on Tenant’s part to be made or performed as provided in this Lease without waiving or releasing Tenant from any obligations of Tenant. All sums so paid by Landlord and all reasonable and necessary incidental costs incurred by Landlord in connection therewith, together with interest thereon at the Default Rate from the date of such payment by Landlord, shall be payable to Landlord on demand as Additional Charges.

26. EXISTING TENANT IMPROVEMENTS; OWNERSHIP OF IMPROVEMENTS; SURRENDER OF PREMISES.

(a) Existing Tenant Improvements. Pursuant to the Existing Lease, Netscape installed certain leasehold improvements and alterations to the Premises which, to the extent they exist within the Premises as of the Effective Date and are not removed or altered in connection with the Initial Alterations are defined for purposes of this Lease as the “Tenant Improvements”.

(b) Ownership of Tenant Improvements & Alterations. The Tenant Improvements and any Alterations constructed on or affixed to the Premises by or on behalf of Tenant pursuant to the terms and conditions of this Lease, except for Tenant’s movable furniture and equipment, trade fixtures and Alterations which can be removed without damage to the Premises, but including without limitation all electrical conduits and wiring and other equipment located in such conduits, shall become Tenant’s property upon the later of their completion or the Commencement Date, shall remain Tenant’s property throughout the Term of this Lease and shall become Landlord’s property upon the expiration or earlier termination of this Lease.

(c) Delivery and Restoration of Premises. At the end of the Term or any renewal thereof or other sooner termination of this Lease, Tenant will peaceably deliver to Landlord possession of the Premises, together with all improvements or additions thereon (including, without limitation, the Tenant Improvements and Alterations which Landlord does not require Tenant to remove, and all electrical conduits, substructures, switches, and wiring located on or under the Premises or Common Area and communications equipment, cable conduits and wiring, and other related equipment located within any such conduits), in the same condition as received or first installed, subject to normal wear and tear but in the condition described on Exhibit “M” attached hereto, subject to the terms of Paragraph 23 [Eminent Domain], and the rights and obligations of Landlord and Tenant concerning casualty damage pursuant to Paragraph 22 [Damage and Destruction]. At Landlord’s election, in lieu of requiring Tenant to restore the Premises (or any portion thereof) to the condition required by this Paragraph, Landlord may require Tenant to pay Landlord the reasonable estimated cost thereof. In addition, upon the termination of this Lease, Tenant shall deliver the electrical facilities and distribution system and the telephone and other communications facilities and equipment serving the Premises (including each Building) in a condition and configuration acceptable at such time for transfer of its ownership and control to Pacific Gas and Electric (or any successor provider of electric services) (“PG&E”) with respect to the electrical distribution system, and in an appropriate and usable condition and configuration for the provision of telephone and other communications services by Pacific Bell (or any successor provider of local telephone services) (“PacBell”) with respect to the communications facilities, such that each Building may be separately metered for electric service and provided with appropriate telephone and other communications service. Any repair, upgrading or reconfiguration of the electrical distribution system or the telephone and other communications facilities and equipment required in order to meet then-existing PG&E requirements or then current PacBell communication standards, as applicable, shall be completed by Tenant, at Tenant’s expense, prior to the termination of the Lease (or, at Landlord’s election, Tenant shall pay Landlord the reasonable estimated cost of such repair, upgrading or reconfiguration). Any cable or electrical or communications conduits or other portions of Tenant’s electrical distribution system or communications system located throughout the Project shall not create any easement, license or other property interest or right of any kind in Tenant, other than Tenant’s right to the use of such improvements pursuant to the terms and conditions of this Lease, and such right shall not survive the expiration or earlier termination of this Lease. Tenant may, upon the termination of this Lease, remove all movable furniture, trade fixtures and equipment belonging to Tenant which is not

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an integral part of any Building System, at Tenant’s sole cost, provided that Tenant repairs any damage caused by such removal. Property not so removed shall be deemed abandoned by Tenant, and title to the same shall thereupon pass to Landlord. Upon request by Landlord, and unless otherwise agreed to in writing by Landlord pursuant to Paragraph 8 [Additional Alterations], Tenant shall either (i) remove, at Tenant’s sole cost, any or all Tenant Improvements, all Alterations to the Premises, all signage identifying Tenant located on Parcel 2 or elsewhere on the Project, and all movable furniture and equipment belonging to Tenant which may be left by Tenant, and repair any damage resulting from such removal, or (ii) pay Landlord the reasonable estimated cost thereof.

(d) No Merger. The voluntary or other surrender of this Lease by Tenant, or a mutual cancellation thereof, shall not work a merger, and shall, at the option of Landlord, terminate all or any existing subleases or subtenancies, or may, at the option of Landlord, operate as an assignment to it of any or all such subleases or subtenancies.

27. WAIVER. If either Landlord or Tenant waives the performance of any term, covenant or condition contained in this Lease, such waiver shall not be deemed to be a waiver of any subsequent breach of the same or any other term, covenant or condition contained herein. Furthermore, the acceptance of Base Rent or Additional Charges by Landlord shall not constitute a waiver of any preceding breach by Tenant of any term, covenant or condition of this Lease, regardless of Landlord’s knowledge of such preceding breach at the time Landlord accepted such Base Rent or Additional Charges. Failure by Landlord to enforce any of the terms, covenants or conditions of this Lease for any length of time shall not be deemed to waive or to decrease the right of Landlord to insist thereafter upon strict performance by Tenant. Waiver by Landlord of any term, covenant or condition contained in this Lease may only be made by a written document signed by Landlord.

28. NOTICES. Except as otherwise expressly provided in this Lease, and except for routine bills or invoices for Base Rent or Additional Charges delivered by Landlord pursuant to Paragraph 4 [Rent] which Landlord may elect to deliver by first class U.S. mail, any bills, statements, notices, demands, requests or other communications given or required to be given under this Lease shall be effective only if rendered or given in writing, sent by certified mail (return receipt requested), reputable overnight carrier, or delivered personally, (i) to Tenant at Tenant’s address set forth in the Basic Lease Information, or (ii) to Landlord at Landlord’s address set forth in the Basic Lease Information; or (iii) to such other address as either Landlord or Tenant may designate as its new address for such purpose by notice given to the other in accordance with the provisions of this Paragraph 28. Any bill, statement, notice, demand, request or other communication shall be deemed to have been rendered or given on the date the return receipt indicates delivery of or refusal of delivery if sent by certified mail, the day upon which recipient accepts and signs for delivery from a reputable overnight carrier or on the date a reputable overnight carrier indicates refusal of delivery, upon the date personal delivery is made, or three (3) days after mailed by first class U.S. mail.

29. TAXES PAYABLE BY TENANT. Prior to delinquency Tenant shall pay all taxes levied or assessed upon Tenant’s equipment, furniture, fixtures and other personal property located in or about the Premises. If the assessed value of Landlord’s property is increased by the inclusion therein of a value placed upon Tenant’s equipment, furniture, fixtures or other personal property, Tenant shall pay to Landlord, upon written demand, the taxes so levied against Landlord, or the proportion thereof resulting from said increase in assessment.

30. ABANDONMENT. Tenant shall not abandon the Premises and cease performing its financial and maintenance obligations under this Lease at any time during the Term. If Tenant abandons and ceases performing its financial and maintenance obligations under this Lease, or surrenders the Premises or is dispossessed by process of law or otherwise, any personal property belonging to Tenant and left on the Premises shall, at the option of Landlord, be deemed to be abandoned and title thereto shall thereupon pass to Landlord. Notwithstanding anything to the contrary contained herein, Tenant may not vacate the Premises if such would result in a termination of Landlord’s insurance. Upon Tenant’s request, Landlord will ask its insurer if such vacation of the Premises would result in termination of its current insurance policy. Solely for purposes of this Paragraph 30, Tenant shall not be deemed to have abandoned the Premises solely because Tenant is not occupying the Premises.

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31. SUCCESSORS AND ASSIGNS. Subject to the provisions of Paragraphs 11 [Assignment and Subletting] and 24 [Sale by Landlord], the terms, covenants and conditions contained herein shall be binding upon and inure to the benefit of the parties hereto and their respective legal and personal representatives, successors and assigns.

32. ATTORNEY’S FEES. If Tenant or Landlord brings any action for any relief against the other, declaratory or otherwise, arising out of this Lease, including any suit by Landlord for the recovery of Base Rent or Additional Charges or possession of the Premises, the losing party shall pay to the prevailing party a reasonable sum for attorney’s fees, which shall be deemed to have accrued on the commencement of such action and shall be paid whether or not the action is prosecuted to judgment.

33. LIGHT AND AIR. Tenant covenants and agrees that no diminution of light, air or view by any structure which may hereafter be erected (whether or not by Landlord) shall entitle Tenant to any reduction of Rent under this Lease, result in any liability of Landlord to Tenant, or in any other way affect this Lease or Tenant’s obligations hereunder.

34. SECURITY FOR LEASE.

(a) Letter of Credit. Prior to the Commencement Date, Tenant shall deliver to Landlord an unconditional, irrevocable, transferable letter of credit, in the amount of Eight Hundred Seventy-One Thousand Two Hundred Ninety-Seven and 50/100 Dollars ($871,297.50), issued by Wells Fargo Bank, or another financial institution reasonably acceptable to Landlord, in the form attached hereto as Exhibit “N”, with an original term of no less than one year and automatic extensions through the end of the Term of this Lease and sixty (60) days thereafter (the “Letter of Credit”). The Letter of Credit shall (i) be a stand-by, at-sight, irrevocable letter of credit; (ii) be payable to Landlord or its assignees (any of the foregoing, the “Beneficiary”); (iii) require that any draw on the Letter of Credit shall be made only upon receipt by the issuer of a letter signed by a purported authorized representative of the Beneficiary certifying that the Beneficiary is entitled to draw on the Letter of Credit pursuant to this Lease; (iv) allow partial draws; and (v) provide that it is governed by the Uniform Customs and Practice for Documentary Credits (1993 revisions) or the International Standby Practices (ISP 98). Tenant shall keep the Letter of Credit, at its expense, in full force and effect until the sixtieth (60th) day after the Expiration Date or other termination of this Lease, to insure the faithful performance by Tenant of all of the covenants, terms and conditions of this Lease. The Letter of Credit shall provide thirty (30) days’ prior written notice to Landlord of cancellation or material change thereof, and shall further provide that, in the event of any nonextension of the Letter of Credit at least thirty (30) days prior to its expiration, the entire face amount shall be payable to Landlord, and Landlord shall hold any funds so obtained as the security deposit required under this Lease. Such funds so obtained by Landlord, or any unused portion thereof, shall be returned to Tenant upon replacement of the Letter of Credit. If Landlord uses any portion of any cash security deposit to cure any default by Tenant hereunder, Tenant shall replenish the security deposit to the original amount within ten (10) days of notice from Landlord. Tenant’s failure to do so shall become a material default under this Lease. If an uncured or incurable default occurs under this Lease, or if Tenant is the subject of an Insolvency Proceeding, Landlord may present its written demand for payment of the entire face amount of the Letter of Credit (or, at Landlord’s sole option, for a portion of such amount) and the funds so obtained shall be paid to, or as otherwise directed by, Landlord. Landlord may retain such funds to the extent required to compensate Landlord for damages incurred, or to reimburse Landlord as provided herein, in connection with any such default, and any remaining funds shall be held as a cash security deposit. Notwithstanding anything contained in this Paragraph 34 to the contrary, if Landlord draws on the Letter of Credit, then Tenant shall have the right, upon ten (10) days’ prior written notice to Landlord, to obtain a refund from Landlord of any unapplied proceeds of the Letter of Credit which Landlord has drawn upon, any such refund being conditioned upon Tenant simultaneously delivering to Landlord a new replacement Letter of Credit in the amount then required, and otherwise meeting the requirements contained in this Paragraph 34.

(b) Reduction. If Tenant has not defaulted under this Lease, and provided the “Credit Requirement” (as defined below) is then satisfied, then the face amount of the Letter of Credit may be reduced to (or a

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replacement Letter of Credit may be provided in the amount of) (i) Five Hundred Eighty Thousand Eight Hundred Sixty-Five Dollars ($580,865.00) on the first anniversary of the Commencement Date, and (ii) Two Hundred Ninety Thousand Four Hundred Thirty-Two and 50/100 Dollars ($290,432.50) on the second anniversary of the Commencement Date. “Credit Requirement” shall mean that Tenant can establish to Landlord’s reasonable satisfaction that Tenant has achieved each of the following, as reflected in audited financial statements (which include an unqualified certification by a licensed certified public accountant reasonably acceptable to Landlord): (a) a tangible net worth (defined as total assets, less good will and any other intangible assets, less liabilities) of at least One Hundred Fifty Million Dollars ($150,000,000), (b) unencumbered and unrestricted cash and marketable securities of Fifty Million Dollars ($50,000,000), and (c) positive net cash provided by operating activities, as reflected in Condensed Consolidated Statements of Cash Flows that are an integral part of Tenant’s financial statements. Tenant shall immediately notify Landlord in writing if Tenant at any time has unencumbered and unrestricted cash and marketable securities of less than Fifty Million Dollars ($50,000,000),

(c) Restoration of Letter of Credit. Following any reduction in the face amount of the Letter of Credit pursuant to Paragraph 34(b), if Landlord reasonably determines that the Credit Requirement is not then satisfied (either based on any financial statement delivered to Landlord pursuant to Paragraph 35 or any other financial statement or information regarding Tenant that is publicly available, or as a result of notice from Tenant pursuant to Paragraph 34(b)), then within ten (10) days after the earlier of Tenant’s delivery of the applicable notice or financial statement to Landlord, or Landlord’s notice to Tenant that Landlord has determined that the Credit Requirement is not then satisfied, Tenant shall deliver to Landlord an amendment to the Letter of Credit increasing the face amount to (or a replacement Letter of Credit may be provided in the amount of ) the full original face amount of the Letter of Credit, and notwithstanding any other provisions of this Paragraph 34, such Letter of Credit shall not be reduced until such time as the Credit Requirement is again satisfied based on subsequent financial statements provided pursuant to Paragraph 35.

(d) Assignment. Landlord shall be entitled to assign the Letter of Credit and its rights thereto from time to time, but only in connection with an assignment of this Lease to a Mortgagee as security for the obligations of Landlord to such Mortgagee, or in connection with a sale or other transfer of Landlord’s interest in Parcel 2, in either case without cost to Landlord. Tenant shall cooperate with Landlord in connection with any modifications of or amendments to the Letter of Credit that may be reasonably requested by any Mortgagee and/or in connection with any such assignment.

(e) Substitution of Cash Collateral. In lieu of, or in replacement of, the Letter of Credit, Tenant may deliver to Landlord at any time during the Term a cash security deposit in the face amount required of the Letter of Credit, provided that Landlord shall have no additional liability or reduced benefits from that which Landlord would have if Tenant provided a Letter of Credit. All terms, conditions and requirements with respect to the Letter of Credit contained in this Paragraph 34, including, without limitation, application of proceeds, reduction of amount, and investment requirements for cash security, shall apply to any such cash security deposit. Landlord shall not be required to hold any cash security deposit in a separate account, and no interest will be payable on any such cash security deposit.

35. FINANCIAL INFORMATION. Tenant will furnish to the Landlord within ninety (90) days after the end of each calendar year, copies of audited, consolidated financial statements, which shall include, without limitation, balance sheets, statements of income and expenses and sources and uses of funds of the Tenant and its subsidiaries for such calendar year, all in reasonable detail and stating in comparative form the figures as of the end of and for the previous calendar year and including appropriate footnotes, prepared in accordance with generally accepted accounting principles, and certified and audited by independent public accountants of recognized standing reasonably satisfactory to the Landlord; provided, however, that so long as Tenant is a publicly traded corporation, in lieu of the foregoing Tenant shall provide Landlord with copies of Tenant’s annual report and 10K Filing when such documents are released to the public. Tenant hereby covenants and warrants to Landlord that all financial information and other descriptive information regarding Tenant’s business, which has been or shall be furnished to Landlord, is and shall be accurate and complete at the time of delivery to Landlord.

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36. PARKING. Tenant shall have the right to use the number of parking spaces in the Common Area and the common area elsewhere in the Project, collectively, which is in the same proportion to the total parking spaces as the Rentable Area of the Premises is to the total rentable area in the Project, which shall not be less than the parking required for Parcel 2 by the City of Mountain View (the “Minimum Parking”). Tenant shall have the right to use the Minimum Parking either on the Common Area or on the common area located in Parcel 1 and/or Parcel 2. These spaces shall be used in common with other tenants and occupants of the Project, if any, subject to the CC&Rs and the Rules and Regulations. Tenant and Landlord acknowledge that the City of Mountain View has approved portions of the common area on Parcel 1 for landscape reserves (the “Landscape Reserves”), and such Landscape Reserves are located on portions of the Common Area that could otherwise accommodate additional parking. If at any time during the Term Tenant desires to increase the parking on the Common Area by the removal or alteration of all or a portion of the Landscape Reserves, any such demolition or alteration shall be accomplished at Tenant’s cost and expense.

37. MISCELLANEOUS.

(a) Defined Terms. The term “Landlord” shall include Landlord and its successors and assigns. In any case where this Lease is signed by more than one person, the obligations hereunder shall be joint and several. The term “Tenant” shall include Tenant and its successors and assigns.

(b) Other Terms. Time is of the essence of this Lease and all of its provisions. This Lease shall in all respects be governed by the laws of the State of California. This Lease, together with its exhibits, contains all the agreements of the parties hereto and supersedes any previous negotiations. There have been no representations made by the Landlord or understandings made between the parties other than those set forth in this Lease and its exhibits. This Lease may not be modified except by a written instrument by the parties hereto, except as expressly and specifically provided in Subparagraphs 1(d) [Reconfiguration of Parcel 2]. The paragraph headings herein are for convenience of reference and shall in no way define, increase, limit or describe the scope or intent of any provision of this Lease. This Lease may be executed in two or more counterparts, each of which shall be deemed an original but all of which together shall constitute one and the same instrument. This Lease shall be effective upon delivery of facsimile signatures, provided, however, that the parties shall promptly thereafter exchange wet ink original signatures.

(c) Quiet Enjoyment. Upon Tenant paying the Base Rent and Additional Charges and performing all of Tenant’s obligations under this Lease, Tenant may peacefully and quietly enjoy the Premises during the Term as against all persons or entities lawfully claiming by or through Landlord; subject, however, to the provisions of this Lease.

(d) Survival of Indemnities; Immediate Obligation to Defend. All indemnities contained herein shall survive the expiration or earlier termination of this Lease. With respect to each of the indemnities contained in this Lease, the indemnitor has an immediate and independent obligation to defend the indemnitee from any claim which actually or potentially falls within the indemnity provision, which obligation arises at the time such claim is tendered to the indemnitor by the indemnitee and continues at all times thereafter.

38. REAL ESTATE BROKERS. Each party represents that it has not had dealings with any real estate broker, finder or other person with respect to this Lease in any manner. Each party shall hold harmless the other party from all damages resulting from any claims that may be asserted against the other party by any broker, finder or other person with whom the other party has or purportedly has dealt.

39. HAZARDOUS MATERIALS LIABILITY. Tenant is aware that Parcel 2 is subject to remediation orders issued by the U.S. Environmental Protection Agency (“EPA”), as disclosed on Exhibit “O”. In addition, Tenant acknowledges that Tenant has received from Landlord a copy of the reports listed on Schedule 1 to Exhibit “O”, and has been given sufficient opportunity to request from Landlord (and, to the extent requested, to obtain and review) the reports listed on Schedule 2 to Exhibit “O” (all such reports being collectively defined as the “Environmental Reports”). In addition, in connection with the remediation orders, the Clean-up Facilities and

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related monitoring and remediation of Hazardous Materials, a Declaration of Restrictions and Access Agreement (as such document may be modified from time to time as provided in Paragraph 6 [Restrictions on Use], the “Declaration”) attached hereto as Exhibit “P” encumbers Parcel 1 and Parcel 2 (including the Premises) and will at all times be superior in priority to this Lease, and Tenant’s occupancy and use of the Premises may be restricted by the Declaration. Landlord shall have the right to modify the Declaration during the Term as may be reasonably required in connection with the remediation of Hazardous Materials and Clean-Up Facilities, so long as such modification does not materially adversely affect Tenant’s Permitted Use of the Premises, Tenant’s Minimum Parking or Tenant’s access to the Premises. If necessary, Tenant shall execute such documents as are reasonably necessary to cause this Lease to become subordinate to the Declaration, as it may be modified from time to time in accordance with the preceding sentence.

(a) Definitions of Hazardous Materials and Environmental Laws. For the purpose of this Lease, “Hazardous Materials” shall be defined, collectively, as any and all substances, chemicals, wastes, sewage or other materials that are now or hereafter regulated, controlled or prohibited by any local, state or federal law or regulation requiring removal, warning or restrictions on the use, generation, disposal or transportation thereof including, without limitation, (a) any substance defined as a “hazardous substance”, “hazardous material”, “hazardous waste”, “toxic substance”, or “air pollutant” in the Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA”), 42 U.S.C. §9601, et seq., the Hazardous Materials Transportation Act, 49 U.S.C. §1801, et seq., the Resource Conservation and Recovery Act (“RCRA”), 42 U.S.C. §6901, et seq., the Federal Water Pollution Control Act (“FWPCA”), 33 U.S.C. §1251 et seq., the Clean Air Act (“CAA”), 42 U.S.C. §7401 et seq., or the Toxic Substances Control Act (“TSCA”), 15 U.S.C. §2601, et seq., all as previously amended and amended hereafter; and (b) any hazardous substance, hazardous waste, toxic substance, toxic waste, air pollutant, hazardous material, waste, chemical, or compound described in any other federal, state, or local statute, ordinance, code, rule, regulation, order, decree or other law now or at any time hereafter in effect regulating, relating to or imposing liability or standards of conduct concerning any hazardous, toxic, or dangerous substance, chemical, material, compound or waste. As used herein, the term “Hazardous Materials” also means and includes, without limitation, asbestos; flammable, explosive or radioactive materials; gasoline or gasoline additives; oil; motor oil; waste oil; petroleum (including, without limitation, crude oil or any component thereof); petroleum-based products; paints and solvents; lead; cyanide; DDT; printing inks; acids; pesticides; ammonium compounds; polychlorinated biphenyls; and other regulated chemical products. The statutes, regulations, court and administrative agency decisions, and other laws now or at any time hereafter in effect that govern or regulate Hazardous Materials are herein collectively referred to as “Environmental Laws”.

(b) Tenant Indemnity. Tenant releases Landlord from any liability for, waives all claims against Landlord and shall indemnify, defend and hold harmless the Landlord Parties against, any and all claims, suits, loss, costs (including costs of investigation, clean up, monitoring, restoration and reasonable attorney fees), damage or liability, whether foreseeable or unforeseeable, by reason of property damage (including diminution in the value of the property of the Landlord Parties), personal injury or death directly arising from or related to Hazardous Materials released, manufactured, discharged, disposed, used or stored on, in, or under Parcel 2 during the Term of this Lease, regardless of who caused the same, except for Hazardous Material (i) which migrates through the air, groundwater or otherwise to Parcel 2 unless the Hazardous Material migrating through the air, soil or groundwater to Parcel 2 originated from a site where Tenant caused the contamination by such Hazardous Material, or (ii) which was present on Parcel 2 immediately prior to the Commencement Date and was not caused by Tenant, its employees, invitees, subtenants, agents, assignees, licensees or servants. The provisions of this Tenant Indemnity regarding Hazardous Materials shall survive the termination of the Lease.

(c) Landlord Indemnity. Landlord releases Tenant from any liability for, waives all claims against Tenant and shall indemnify, defend and hold harmless Tenant, its officers, employees, and agents to the extent of Landlord’s interest in Parcel 2, against any and all actions by any governmental agency for clean up of Hazardous Materials on or under Parcel 2, including costs of legal proceedings, investigation, clean

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up, monitoring, and restoration, including reasonable attorney fees, if, and to the extent, the Hazardous Materials occur on Parcel 2 under the following circumstances: (i) the Hazardous Materials are not “Identified Hazardous Materials” or “Existing Hazardous Materials” (as both terms are defined in the Seller Indemnity), and were released or disposed of on property which was not at the time of such disposal or release leased, owned or otherwise used or controlled by Tenant and such Hazardous Material migrated through the air or groundwater to Parcel 2; or (ii) the contamination of Parcel 2 was caused by the release, disposal, use or storage of Hazardous Materials in, on or about Parcel 2 by Landlord, its employees, agents, licensees or servants. The provisions of this Landlord Indemnity regarding Hazardous Materials shall survive the termination of the Lease.

(d) Seller Indemnity. Landlord has obtained from Seller an indemnity with respect to certain Hazardous Materials existing on Parcel 2 as of the date of Landlord’s acquisition of Parcel 2, a copy of which is attached hereto as Exhibit “Q” (the “Seller Indemnity”), and Tenant shall have such benefits thereunder as are available to tenants on Parcel 2.

(e) Release of Landlord. Notwithstanding any other provision of this Lease, Tenant releases the Landlord Parties from any liability for, and waives all claims against the Landlord Parties with respect to, the presence of Hazardous Materials in, on or about Parcel 2 prior to the Commencement Date (except claims and liability which are included in Landlord’s indemnity contained in (c) above and not covered by the Seller Indemnity). Tenant agrees that its recourse with respect to any liability or claims released by this Paragraph shall be limited to direct claims against Seller pursuant to the Seller Indemnity.

(f) Tenant’s Disclosure Obligations. Tenant represents that during the Term it will not be a User (as such term is defined in the Seller Indemnity attached as Exhibit “Q”). Except for immaterial amounts of toxic materials incidental to office use (e.g. copier toner, cleaning supplies, petroleum products in cars), hydraulic fluids used in Building Systems, Hazardous Materials used in the operation of any generators, and those materials listed on Exhibit “R”, Tenant will not use any Hazardous Materials within Parcel 2 and shall comply with any applicable Environmental Laws and with the Seller Indemnity as it relates to Tenant. Without limiting the foregoing, Tenant shall not use any Hazardous Materials within Parcel 2 in a manner that would reduce or limit Seller’s obligations under the Seller Indemnity. Tenant shall immediately notify Landlord and Seller if and when Tenant learns or has reason to believe there has been any release of Hazardous Materials in, on or about the Project during the Term.

40. ARBITRATION OF DISPUTES.

ANY CONTROVERSY OR CLAIM ARISING OUT OF THE SPECIFIC PROVISIONS OF THE LEASE LISTED BELOW, OR ANY OTHER PROVISION OF THIS LEASE THAT EXPRESSLY PROVIDES FOR ARBITRATION PURSUANT TO THIS PARAGRAPH, OR A BREACH OF ANY SUCH PARAGRAPHS OR PROVISIONS SOLELY BETWEEN LANDLORD AND TENANT, BUT NOT INCLUDING A DEFAULT WITH RESPECT TO THE TIMELY PAYMENT OF BASE RENT AND ADDITIONAL CHARGES, SHALL BE SETTLED BY ARBITRATION IN ACCORDANCE WITH THE RULES OF THE AMERICAN ARBITRATION ASSOCIATION, AND JUDGMENT ON THE AWARD RENDERED BY THE ARBITRATOR(S) MAY BE ENTERED IN ANY COURT HAVING JURISDICTION. THE PREVAILING PARTY IN SUCH ARBITRATION SHALL BE ENTITLED TO ATTORNEYS’ FEES AND COSTS. THE FOLLOWING PROVISIONS OF THIS LEASE SHALL BE SUBJECT TO ARBITRATION PURSUANT TO THIS PARAGRAPH 40:

(1) SUBPARAGRAPH 1(b)(iii) [PROJECT; COMMON AREAS; ACCESS AND COOPERATION], ONLY WITH RESPECT TO MODIFICATIONS TO CC&RS;

(2) SUBPARAGRAPH 1(b)(iv) [PROJECT; COMMON AREAS; ACCESS AND COOPERATION], ONLY WITH RESPECT TO ACCESS, ENCUMBRANCES AND COOPERATION;

(3) SUBPARAGRAPH 1(c) [RECONFIGURATION OF PARCEL 2];

(4) SUBPARAGRAPH 1(d) [CONSTRUCTION ON PARCEL 2];

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(5) PARAGRAPH 2 [OCCUPANCY AND USE], ONLY WITH RESPECT TO WHETHER TENANT’S USE COMPLIES WITH THE USE SPECIFIED IN THE BASIC LEASE INFORMATION;

(6) SUBPARAGRAPH 3(b) [NO REPRESENTATIONS/OBLIGATIONS], ONLY WITH RESPECT TO LANDLORD’S ENFORCEMENT OF CONSTRUCTION WARRANTIES;

(7) SUBPARAGRAPH 4(d) [AUDIT RIGHTS];

(8) PARAGRAPH 5 [MANAGEMENT];

(9) PARAGRAPH 6 [RESTRICTIONS ON USE], ONLY WITH RESPECT TO MODIFICATIONS TO EXHIBIT G AND/OR THE RESTRICTIVE DOCUMENTS;

(10) PARAGRAPH 7 [COMPLIANCE WITH LAWS];

(11) PARAGRAPH 8 [ADDITIONAL ALTERATIONS];

(12) PARAGRAPH 9 [REPAIRS AND MAINTENANCE];

(13) PARAGRAPH 11 [ASSIGNMENT AND SUBLETTING];

(14) SUBPARAGRAPHS 14(b) [NO EXCESSIVE LOAD] AND 14(c) [NO LIABILITY OF LANDLORD];

(15) SUBPARAGRAPH 18 [RULES AND REGULATIONS];

(16) SUBPARAGRAPH 22(c) [CASUALTY AT END OF TERM], ONLY WITH RESPECT TO WHETHER A SUBSTANTIAL PORTION OF A BUILDING IS DAMAGED OR DESTROYED;

(17) SUBPARAGRAPHS 22(d) [MUTUAL TERMINATION OPTION; INSURED CASUALTY] AND 22(e) [DESTRUCTION WHERE NO PROCEEDS ARE AVAILABLE], ONLY WITH RESPECT LANDLORD’S DETERMINATION OF THE LENGTH OF TIME TO RECONSTRUCT;

(18) SUBPARAGRAPH 23(b) [PARTIAL BUILDING; TERMINATION], ONLY WITH RESPECT TO WHETHER THE PORTION TAKEN RENDERS THE REMAINING BUILDING UNSUITABLE FOR EXISTING USE;

(19) SUBPARAGRAPH 23(e) [TAKING OF COMMON AREA];

(20) SUBPARAGRAPH 26(b) [DELIVERY AND RESTORATION OF PREMISES];

(21) PARAGRAPH 36 [PARKING]; AND

(22) PARAGRAPH 41 [SIGNAGE].

NOTICE: BY INITIALING IN THE SPACE BELOW YOU ARE AGREEING TO HAVE ANY DISPUTE ARISING OUT OF THE MATTERS INCLUDED IN THE “ARBITRATION OF DISPUTES” PROVISION DECIDED BY NEUTRAL ARBITRATION AS PROVIDED BY CALIFORNIA LAW AND YOU ARE GIVING UP ANY RIGHTS YOU MIGHT POSSESS TO HAVE THE DISPUTE LITIGATED IN A COURT OR JURY TRIAL. BY INITIALING IN THE SPACE BELOW YOU ARE GIVING UP YOUR JUDICIAL RIGHTS TO DISCOVERY AND APPEAL, UNLESS THOSE RIGHTS ARE SPECIFICALLY INCLUDED IN THE “ARBITRATION OF DISPUTES” PROVISION. IF YOU REFUSE TO SUBMIT TO ARBITRATION AFTER AGREEING TO THIS PROVISION, YOU MAY BE COMPELLED TO ARBITRATE UNDER THE AUTHORITY OF THE CALIFORNIA CODE OF CIVIL PROCEDURE. YOUR AGREEMENT TO THIS ARBITRATION PROVISION IS VOLUNTARY.

WE HAVE READ AND UNDERSTAND THE FOREGOING AND AGREE TO SUBMIT DISPUTES ARISING OUT OF THE MATTERS INCLUDED IN THE “ARBITRATION OF DISPUTES” PROVISION TO NEUTRAL ARBITRATION.

Consent to neutral arbitration by:

                                                  (Landlord):                                                   (Tenant).

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41. SIGNAGE. Tenant shall have the right to use two monument signs (i) one sign located on a stone wall at Whisman entrance to Parcel 2 and which is similar in size and appearance to the existing monument sign used by Netscape at the Whisman entrance to Parcel 2 (the “Netscape Sign”), in an area next to the Netscape Sign as more specifically designated by Landlord and reasonably acceptable to Tenant, and (ii) an additional sign located on a stone wall at the Ellis entrance to Parcel 1, which is similar in size and appearance to the Netscape sign, in an area as more specifically designated by Landlord and reasonably acceptable to Tenant, both for purposes of attaching lettering identifying Tenant’s use and occupancy at the Project. Tenant shall be responsible for all costs related to such signage. In addition, Tenant shall have the right, at Tenant’s sole cost and expense, to install and display its company name above the main entrance of each Building, on the entry doors of each Building, and within the lobby of each Building. All of such signage shall be subject to approval from Landlord and applicable governing entities, and such signage shall not violate the Declaration, the CC&Rs, any ground lease, any Mortgage, or any Rules and Regulations with respect to the Project.

42. RIGHT OF FIRST NEGOTIATION. Tenant shall have a one-time right of first negotiation with respect to a lease of the entire Building 8, on the terms and conditions of this Paragraph 42. Tenant’s rights under this Paragraph 42 shall not arise unless and until Landlord elects, in its sole discretion, to commence construction of Building 8. Landlord shall provide written notice to Tenant (“Trigger Notice”) if and when Landlord determines that it will construct Building 8, prior to commencing negotiations for a lease of such space with another party. Tenant shall have five (5) business days following the receipt of the Trigger Notice to deliver written notice to Landlord of Tenant’s desire to negotiate to lease the entire Building 8 (“Interest Notice”). If Tenant timely delivers the Interest Notice, Tenant’s exclusive right to negotiate shall extend for a total of thirty (30) days from the date of the Trigger Notice, provided that such thirty (30) day period may be extended by mutual written agreement of Landlord and Tenant. If Tenant fails to timely deliver the Interest Notice, or if Landlord and Tenant have not entered into a written contract of lease within such thirty day period (and Landlord and Tenant shall be under no duty to enter into such a contract of lease), Tenant’s rights under this Paragraph 42 shall terminate. Tenant’s rights under this Paragraph 42 shall only be binding upon the originally named Landlord under this Lease, and shall not be binding upon any purchaser, lender or other successor to Landlord’s interest in Parcel 2. Landlord agrees not to transfer only that portion of Parcel 2 upon which Building 8 would be constructed for purposes of circumventing Tenant’s right of first negotiation pursuant to this Paragraph 42. Tenant’s rights under this Paragraph 42 shall only benefit the originally named Tenant under this Lease and any assignee arising out of a Permitted Transfer, are not otherwise transferable and shall not inure to the benefit of any sublessees or other assigns of Tenant’s interest under this Lease. Tenant’s rights under this Paragraph 42 shall terminate at such time as Tenant no longer occupies at least sixty percent (60%) of the Premises for Tenant’s own use (exclusive of the occupancy of subtenants, assignees and licensees). Neither Landlord nor Tenant has had any contract or dealings regarding Building 8 through any licensed real estate broker or other person who may claim a right to a commission or finder’s fee as a procuring cause of any lease that might be entered into in respect of Building 8. If any broker or finder makes a claim for a commission or finder’s fee based upon any such contact, dealings, or communications, the party through whom the broker or finder makes his claim shall be responsible for said commission or fee, and all costs and expenses (including reasonable attorneys’ fees) incurred by the other party in defending against such claim.

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IN WITNESS WHEREOF, the parties hereto have executed this Lease as of the date first above written.

LANDLORD
369 Whisman Street Associates, L.P., a California limited partnership
By:	Cañada Corp., a California corporation, Its General Partner
	By:	/s/    JOYCE YAMAGIWA
	Its:	Vice President
By:	Virginia Land Company, Inc., a California corporation, Its General Partner
	By:	/s/    JOHN B. LOVEWELL
	Its:	Manager and President
TENANT
Mercury Interactive Corporation, a Delaware corporation
By:	/s/    SUSAN J. SKAER
Its:	Vice President, General Counsel & Secretary

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LIST OF EXHIBITS

Exhibit “A”	Site Plan (showing the Buildings)
Exhibit “B”	Parcel Map
Exhibit “C”	CC&Rs
Exhibit “D”	Approved Additional Construction
Exhibit “E”	Closing Certificate
Exhibit “F”	Commencement Date Memorandum
Exhibit “G”	Restrictions on Use
Exhibit “H”	January 14, 1997 Letter from Perry Palmer to Ed Axelson
Exhibit “I”	Maintenance Standards and Schedule (to be attached if/when adopted)
Exhibit “J”	Estoppel Certificate
Exhibit “K”	Form of SNDA
Exhibit “L”	Rules & Regulations
Exhibit “M”	Required Condition of Premises Upon Surrender
Exhibit “N”	Form of Letter of Credit
Exhibit “O”	Landlord’s Hazardous Materials Disclosures
Exhibit “P”	Form of Declaration of Restrictions and Access Agreement
Exhibit “Q”	Seller’s Indemnity
Exhibit “R”	Tenant’s Hazardous Materials Disclosures

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EX-10.20

EXHIBIT 10.20

AMENDED AND RESTATED

REPLACES LETTER DATED OCTOBER 1, 2003

December 23, 2003

Via Hand Delivery

Kenneth Klein

Dear Ken:

This letter, upon your signature, will be the agreement (this “Agreement”) between you and Mercury Interactive Corporation (“Mercury” or the “Company”) on the terms of the change in your employment status with Mercury.

1. Your term of full time employment at Mercury, and your role as Chief Operating Officer and your service on the Board of Directors, will end effective December 31, 2003 (the “Transition Date”). After the Transition Date, you will have 30 days to exercise your vested stock options in accordance with the terms of the applicable option agreement, except as provided in Section 2(b) below. You will be eligible for COBRA coverage commencing January 1, 2004. On or before December 31, 2003, you will be paid your accrued vacation of $185,455.78.

2. Although you are not otherwise entitled to it, in consideration of your acceptance of this Agreement, Mercury will provide you with the following:

(a) During the period from January 1, 2004 through October 3, 2005 (the “Transition Period”), Mercury will pay you $29,166.67 per month in accordance with Mercury’s standard payroll practices, less applicable taxes. You will also receive (at or about the same time as the date it is paid to other Mercury executives), your annual bonus of $250,000.00 for the year ending December 31, 2003. Thereafter, you will also receive a similar bonus payment for the year ending December 31, 2004 (paid at 100% or such other percentage as the other Mercury executives receive based on the Company’s performance for that year), when other executives are paid their bonuses for 2004. Finally, you will receive a pro-rated bonus for 2005 in the amount of $187,500.00 (or an amount equal to the prorated portion of your annual bonus for 2005 paid at the same percentage rate as the other Mercury executives receive based on the Company’s performance) at the end of the Transition Period. Please note that all bonus payments are subject to all appropriate tax and related withholding requirements.

(b) Those stock options that would have otherwise vested during the Transition Period (as set forth on Exhibit B, the “Accelerated Options”) will be accelerated and shall be vested immediately effective as of the date of the action of the Compensation Committee of the Board of Directors (and in any event prior to December 31, 2003). Notwithstanding the terms of your option agreement, the Accelerated Options shall be exercisable until October 3, 2005. In addition, the vested portion of your stock option to purchase 350,000 shares with an exercise price of $60.875 that was granted on January 8, 2001 (the “Underwater Option”) shall also be exercisable until October 3, 2005. There are no changes to any options other than the Accelerated Options and the Underwater Option.

(c) Your laptop, RIM and cell phone will become your personal property.

(d) Mercury will transfer ownership of the Mercedes Benz CL500 that Mercury purchased for your business use to you promptly after December 31, 2003 provided, however, that Mercury will withhold from your salary, bonus or other amounts due to you by Mercury all applicable taxes on such car based on the then Kelly Blue Book value (expected to be no more than approximately $77,000).

(e) The parties acknowledge that the outstanding loan from stock option exercises has been paid in full.

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(f) Upon a Change of Control (as defined on Exhibit A), all consideration due and owing under this letter agreement will accelerate and become immediately due and payable to you.

3. You agree that the Change of Control Agreement between you and Mercury dated July 22, 1998 is terminated effective as of December 31, 2003.

4. You hereby affirm all of the provisions set forth in the Mercury Interactive Corporation Proprietary Information Agreement that you signed upon joining the Company as copy of which is attached hereto as Exhibit A.

5. You further agree, in exchange for the benefits provided above, that until the end of the Transition Period:

(a) you will not work for any business, whether as an employee, consultant or advisor, that is a competitor of Mercury. Competition is defined as: companies that sell application management (application performance management), application delivery (testing, tuning and deployment assurance) or IT Governance products and services including such companies as: Computer Associates, Compuware, BMC, Empirix, IBM, IBM Global Services, IBM Software, Keynote, Micromuse, Quest, Radview, Segue and Tivoli.

(b) and for a period of twelve (12) months thereafter, you will not personally solicit or recruit any of the Company’s employees to leave their employment (provided that for this purpose, a general employment advertisement by an entity of which you are a part will not constitute solicitation or recruitment and nothing in this Section 5(b) shall prevent any entity of which you are a part from hiring a Company employee).

(c) you agree that you will not actively counsel or assist any attorneys or their clients in the presentation or prosecution of any disputes, differences, grievances, claims, charges, or complaints by any third party against the Company and/or any officer, director, employee, agent, representative, shareholder or attorney of the Company, unless under a subpoena or other court order to do so or unless otherwise required by law to do so.

(d) if you materially breach any of the terms of this Agreement, that you, from the time of such material breach forward, shall not be entitled to any further payments or benefits under this Agreement, including but not limited to any further vesting under Mercury’s stock option plan; provided however, that in the case of a material breach, Mercury will provide you with written notice of such breach and you shall have 10 days from the date of such notice to cure such material breach (if such breach is capable of being cured).

6. With the exception of the breach of this Agreement by Mercury, you waive and release and promise never to assert any and all claims that you have or might have against Mercury and its predecessors, subsidiaries, related entities, officers, directors, shareholders, agents, attorneys, employees, successors, or assigns (collectively, the “Released Parties”), arising from or related to your employment with Mercury (other than your rights to receive your account balance under the Mercury 401(k) plan) and/or the termination of your employment with Mercury or any other claim that arises after the effective date of this Agreement.

These claims include, but are not limited to, claims arising under federal, state and local statutory or common law, such as the California Fair Employment and Housing Act, the California Labor Code, Title VII of the Civil Rights Act of 1964; the Americans with Disabilities Act, and the law of contract and tort (collectively, the “Released Claims”).

You agree that you will not file (or ask or allow anyone to file on your behalf), any charge, complaint, claim or lawsuit of any kind in connection with any claim released by this Agreement. This provision shall not apply, however, to any non-waivable charges or claims brought before any governmental agency. With respect to any such non-waivable claims, you agree to waive your right (if any) to any monetary or other recovery should any governmental agency or other third party pursue any claims on your behalf, either individually, or as part of any collective action. Nothing herein shall preclude any claim you may file alleging that your waiver of claims under the Age Discrimination in Employment Act of 1967 (“ADEA”) was not knowing or voluntary.

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You understand that the Released Claims include not only claims presently known to you, but also include all unknown claims and causes of action of any kind which would otherwise come within the scope of the Released Claims as described in above in this section 6. You therefore waive your rights under section 1542 of the Civil Code of California, which states:

A general release does not extend to claims which the creditor does not know or suspect to exist in his favor at the time of executing the release, which if known to him must have materially affected his settlement with the debtor.

7. You will not, unless required or otherwise permitted by law, until after such time as the terms of this agreement have been publicly disclosed by Mercury, disclose to others any information regarding the terms of this Agreement, the benefit being paid under it or the fact of its payment, except that you may disclose this information to your attorney, accountant or other professional advisor to whom you must make the disclosure in order for them to render professional services to you. You will instruct them, however, to maintain the confidentiality of this information just as you must.

8. You and Mercury agree to work together on a mutually acceptable press release regarding your transition from the Company. You and Mercury, its officers and directors, agree to refrain from any disparagement, criticism, defamation, slander of the other or tortious interference with the contracts and relationships of the other. In discussing your employment with and transition from the Company, you, Mercury and Mercury’s officer and directors will not in any material way, deviate from or expand upon the discussion in the press release.

9. Unless accepted in the manner set forth below on or before December 31, 2003, this Agreement will expire and become of no further legal effect or consequence.

To accept the agreement, please date and sign this letter and return it to me. Ken, I hope that we will be able to part ways on these amicable terms. Mercury Interactive Corporation and I wish you every success in your future endeavors.

Very truly yours,

MERCURY INTERACTIVE CORPORATION

/s/    SUSAN J. SKAER        

Susan J. Skaer

Vice President, General Counsel and Secretary

By signing this letter, I acknowledge that I have had the opportunity to review this Agreement carefully with an attorney of my choice, that I understand the terms of the agreement, and that I voluntarily agree to them.

Dated: 12/30/03

/s/    KENNETH KLEIN        

Kenneth Klein

Page 3

EXHIBIT A

Definition of “Change of Control”.

“Change of Control” means the occurrence of any of the following events:

(a) Any “person” (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended), excluding existing beneficial owners as of the date of this Letter, is or becomes the “beneficial owner” (as defined in Section 13d-3 of said Act), directly or indirectly, of securities of the Company representing 50% or more of the total voting power represented by the Company’s then outstanding voting securities, excluding conversion of any convertible securities issued as of the date of this Letter;

(b) The composition of the Board of Directors changes during any period of 36 months such that individuals who at the beginning of the period were members of the Board of Directors (the “Continuing Directors”) cease for any reason to constitute at least a majority thereof; unless at least 66 ²/3% of the Continuing Directors has either (i) approved the election of the new Directors, (ii) if the election of the new Directors is voted on by shareholders, recommended that the shareholders vote for approval, or (iii) otherwise determined that such change in composition does not constitute a Change of Control, even if the Continuing Directors do not constitute a quorum of the whole Board (it being understood that this requirement shall not be capable of satisfaction unless there is at least one Continuing Director);

(c) The shareholders of the Company approve a merger or consolidation of the Company with any other corporation, other than a merger or consolidation which would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least 50% of the total voting power represented by the voting securities of the Company or such surviving entity outstanding immediately after such merger or consolidation, or the shareholders of the Company approve a plan of complete liquidation of the Company or an agreement for the sale or disposition by the Company of all or substantially all of the Company’s assets;

(d) Any other provision of this subsection notwithstanding, the term Change of Control shall not include either of the following events undertaken at the election of the Company:

(i) Any transaction, the sole purpose of which is to change the state of the Company’s incorporation; or

(ii) A transaction, the result of which is to sell all or substantially all of the assets of the Company to another corporation (the “surviving corporation”) provided that the surviving corporation is owned directly or indirectly by the shareholders of the Company immediately following such transaction in substantially the same proportions as their ownership of the Company’s common stock immediately preceding such transaction.

Page 4

EXHIBIT B

Accelerated Options

Option Number	Option Date	Exercise Price		Shares subject to accelerated vesting (reflecting vesting from 12/31/03 to 10/3/05)
00001619	1/6/00	$	40.7188	6,250
00003750	1/8/01	$	60.8750	94,792
00007775	1/22/02	$	29.2900	153,125
0001114	1/3/03	$	31.4100	120,312

Page 5

EX-21.1

EXHIBIT 21.1

SUBSIDIARIES OF MERCURY INTERACTIVE CORPORATION

SUBSIDIARY LEGAL NAME	JURISDICTION OF INCORPORATION
Mercury Interactive Austria GesmbH	Austria
Mercury Interactive Brasil Limitada	Brazil
Mercury Interactive Canada, Inc.	Canada
Mercury Interactive A/S	Denmark
Mercury Interactive Oy	Finland
Mercury Interactive (Hong Kong) Limited	Hong Kong
Mercury Interactive (Israel) Limited	Israel
Mercury Interactive (Australia) Pty Ltd. (1)	Australia
Mercury Interactive Srl (2)	Italy
Mercury Interactive Japan K.K.	Japan
Mercury Interactive (Korea) Co. Ltd.	Korea
Mercury Interactive B.V.	Netherlands
Mercury Interactive (Luxembourg) S.A.	Luxembourg
Mercury Interactive (Europe) B.V. (Holding Company – Not operating)	Netherlands
Mercury Interactive France S.A.S.	France
Mercury Interactive Germany GmbH	Germany
Mercury Interactive (UK) Limited	United Kingdom
Mercury Interactive (Singapore) Pte Ltd.	Singapore
Mercury Interactive Sales and Service India Private Limited (3)	India
Mercury Interactive SA (Pty) Ltd.	South Africa
Mercury Interactive S.L. Unipersonal	Spain
Mercury Interactive Nordic AB	Sweden
Mercury Interactive (Switzerland) GmbH	Switzerland
Mercury Interactive Freshwater, Inc.	California
Performant, Inc.	Delaware
Kanga Acquisition LLC	Delaware

(1) 50% interest owned by Mercury Interactive Corporation and 50% interest owned by Mercury Interactive (Israel) Limited

(2) 95% interest owned by Mercury Interactive Corporation and 5% interest owned by Mercury Interactive B.V.

(3) 99% interest owned by Mercury Interactive Corporation and 1% interest owned by Mercury Interactive (Singapore) Pte Ltd.

EX-23.1

Exhibit 23.1

CONSENT OF INDEPENDENT AUDITORS

We hereby consent to the incorporation by reference in the Registration Statements on Form S-8 (No. 33-71018, 33-74728, 33-95178, 333-09913, 333-27951, 333-62125, 333-81401, 333-94837, 333-47140, 333-56316, 333-61786, 333-83064, 333-98031, 333-103214, 333-106646, 333-108266, and 333-111915) and the Registration Statements on Form S-3 (No. 333-106515) of Mercury Interactive Corporation of our report dated January 19, 2004, except for Note 17, which is as of February 8, 2004 relating to the financial statements, which appear in this Form 10-K.

/s/    PricewaterhouseCoopers LLP

San Jose, California

March 5, 2004

EX-31.1

Exhibit 31.1

CERTIFICATION OF CEO PURSUANT TO SECURITIES EXCHANGE ACT

RULES 13A — 14 AND 15D — 14 AS ADOPTED

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Amnon Landan, certify that:

1. I have reviewed this annual report on Form 10-K of Mercury Interactive Corporation;

2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

d) Disclosed in this annual report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 5, 2004

/s/ Amnon Landan

Amnon Landan

President, Chief Executive Officer and Chairman of the Board

EX-31.2

Exhibit 31.2

CERTIFICATION OF CFO PURSUANT TO SECURITIES EXCHANGE ACT

RULES 13A — 14 AND 15D — 14 AS ADOPTED

PURSUANT TO SECTION 302 OF THE SARBANES-OXLEY ACT OF 2002

I, Douglas P. Smith, certify that:

1. I have reviewed this annual report on Form 10-K of Mercury Interactive Corporation;

3. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;

4. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;

5. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;

b) Paragraph omitted pursuant to SEC Release Nos. 33-8238 and 34-47986;

c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this annual report based on such evaluation; and

d) Disclosed in this annual report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

6. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 5, 2004

/s/ Douglas P. Smith

Douglas P. Smith

Executive Vice President and Chief Financial Officer

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The certification set forth below is being submitted in connection with this annual report on Form 10-K of Mercury Interactive Corporation (the Report) for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 (the Exchange Act) and Section 1350 of Chapter 63 of Title 18 of the United States Code.

I, Amnon Landan, Chief Executive Officer of Mercury Interactive, certify that, to the best of my knowledge:

(1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and

(2) the information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of Mercury Interactive Corporation.

Date: March 5, 2004

/s/ Amnon Landan

Amnon Landan

President, Chief Executive Officer and Chairman of the Board

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

The certification set forth below is being submitted in connection with this annual report on Form 10-K of Mercury Interactive Corporation (the Report) for the purpose of complying with Rule 13a-14(b) or Rule 15d-14(b) of the Securities Exchange Act of 1934 (the Exchange Act) and Section 1350 of Chapter 63 of Title 18 of the United States Code.

I, Douglas P. Smith, Chief Financial Officer of Mercury Interactive, certify that, to the best of my knowledge:

(1) the Report fully complies with the requirements of Section 13(a) or 15(d) of the Exchange Act; and

(2) the information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of Mercury Interactive Corporation.

Date: March 5, 2004

/s/ Douglas P. Smith

Douglas P. Smith

Executive Vice President and Chief Financial Officer